We made it. Here in the windy city if you can make it through January and February you are basically home free. The days are getting longer and warmer signaling spring just around the corner. Funny thing – as I get older winters here seem to get longer and colder. Must be that climate change everyone has been talking about. Up next – March Madness.
Over the last several weeks we have done a quick review of the greeks. We have gone over delta, gamma, theta and vega. Those are the main four. The ones that 99% of traders will need to focus on in their trading. However, there is one more that gets much less attention that warrants at least a mention.
Options are levered instruments. Therefore their relative value compared to trading stock or underlying in the cash market is affected by interest rates. The effect on options of the change in interest rates in known as Rho. Rho measures how a 1% change in interest rates affects option prices.
For example, if rho is 10, than a 1% increase in interest rates means that option prices should theoretically go up by 10%. Intuitively this makes sense. If I can buy 100 shares of IBM for $20,000 and my borrowing cost are 0 than there is really no advantage to buying a call option, which will allow me to control 100 shares with much less out of pocket cost. However, if rates go up, then the borrowing cost to buy the same 100 shares may become significant. Now the call becomes more attractive as my out of pocket and hence overall borrowing costs is less. Therefore as rates go up the call price goes up.
On the other hand puts go down as rates rise. Think of that like this. Puts are a substitute for being short the stock. If rates are high, some may get what is called a short stock rebate if they are short the stock. This is basically a rate paid for the cash received by selling the stock. Higher rates – more cash received. Therefore, all else equal, it is more attractive to be short stock than long puts in these higher rate environments. As you might expect, rho becomes more relevant in either higher interest rate environments or when we are dealing with longer dated options. The farther out we go in time, the less certain interest rates are and the greater potential for movement. However, for most options traders concentrating on options 6 months or less, especially in the current low rate environment, interest rate risk is not much of a concern.