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RHO: Why Interest Rates Effect Our Option Premiums

Interest rates and the option Greeks play an important role in understanding option trading basics. Rho, not considered a major Greek, measures the change in an option’s price resulting from a 1% change in interest rates. When interest rates do change, it is normally by 25 basis points, not a full percentage point and that’s why option prices will not be heavily impacted in the short-term by interest rates.

However, as Blue Collar Investors, we need to be educated in all aspects of our investment strategies and interest rates do play a role. Let’s start with a basic premise:

When the interest rate rises by 1%, call value will increase by the amount of its rho and put value will decrease by the amount of its rho.

Here is an example from an options calculator (www.cboe.com) showing a positive rho for calls and a negative rho for puts as interest rates increase:

interest rates and option premiums for covered call writing and put-selling

Rho for calls and puts

For the 21-day period until expiration, the interest rate is 0.1535 (left side), the cost to own the shares (if the money to purchase the shares are borrowed or the interest lost if not borrowed). Should interest rates increase by 1%, the call value will increase by 1.38 cents and the put value will decline by 1.35 cents from the current value of $1.70 (right side). Given that interest rates generally change by 25 basis points when there is an adjustment, the practical impact on our option premiums would be one fourth these amounts. We can now understand why rho is considered a minor Greek.

Why rising interest rates increase call value

There is an interest advantage to buying call options. Let’s assume for a moment that we are interested in a $60 stock and want to purchase 300 shares. The cost before commissions is $18,000. Now if a $30 call can be purchases at parity (intrinsic value only or $30- the amount the strike is in-the-money), the cost would be cut in half to $9,000. The risk is cut in half and the reward is nearly the same. Now the $9,000 not spent on buying the shares can be deposited into an interest-bearing account to generate income. The higher the interest rates, the more valuable call options become and so the rho impacts calls in a positive manner as interest rates rise.

Why rising interest rates decrease put value

There is an interest disadvantage to buying puts. There is a theoretical cost to buying puts, the interest cost to buy the options. We benefit when share price declines and put value then accelerates in much the way professional traders benefit from shorting stocks. When a stock is shorted, cash is generated into the brokerage account which will result in an interest credit (professional traders do pay some interest for borrowing shares that were shorted). The choice then becomes do these traders pay interest as puts are purchased or do they receive interest as shares are shorted? As interest rates increase, put-buying becomes less attractive and stock shorting becomes more attractive (mainly for professional traders who impact option value much more than we do).

Summary

Rho is a minor Greek, impacting option premiums as interest rates change. Call and put premiums are impacted inversely as rates rise or fall. Understanding how and why interest rates effect option premiums make us all better investors.

 

Next live seminar (click on city for more information)

Las Vegas, Nevada

Friday, November 21st

 

Recent interview on The Financial Survival Network

http://financialsurvivalnetwork.com/2014/11/alan-ellman-easy-strategy-to-protect-your-stocks-from-major-corrections/

Market tone

There were few economic reports this past week although there were some potentially positive economic news regarding changes in tariff requirements in China and India:

  • According to the Commerce Department, retail sales increased by 0.3% in October compared to the 0.2% expected
  • According to the Commerce Department, business inventories rose by 0.3% in September, better than the 0.2% anticipated

For the week, the S&P 500 edged up 0.4%, for a year-to-date return of 12%, including dividends.

Summary

IBD: Confirmed uptrend

GMI:6/6- Buy signal since market close of October 27, 2014

BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

13 Responses to “RHO: Why Interest Rates Effect Our Option Premiums”

  1. Barry B November 15, 2014 8:49 pm #

    BCI Community,

    It is with great joy that I’m honored to share some wonderful news. Earlier today, Alan was blessed with the birth of his second grandchild, Jordan Walker. Jordan, at 8 lbs. 1 oz and his Mom are both doing great. Please join me in wishing Alan and his family best wishes.

    Barry and The Blue Collar Team

  2. Barry B November 16, 2014 12:45 am #

    Premium Members,
    This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 11-14-14.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    Since we are in Earnings Season, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:

    http://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

    Best,
    Barry and The BCI Team

  3. Eric November 16, 2014 4:38 pm #

    Alan,

    I’ve been looking for Dec 20th expiration options. The option chains show those options are currently available. Is there a reason I would need to wait until the Nov options expire at the end of this week? Will new options become available after the Nov expiration?

    I appreciate the support.

    Thanks

    Eric

    • Alan Ellman November 16, 2014 4:48 pm #

      Eric,

      Every option that is currently listed can be bought or sold at any time. This includes the December monthly expirations. The longer we are in a short options position, the more risk exposure we have to a trade turning against us. The question that must be asked and answered is whether the reward of additional days to expiration justifies the additional time exposure risk.

      Since time value erosion (theta)is logarithmic for near-the-money strikes (decay starts off slowly and picks up steam as expiration approaches), waiting until the November contracts expire will usually not deteriorate premiums significantly and will reduce our risk exposure by a week.

      Alan

  4. Adrian November 17, 2014 12:55 am #

    Alan, thanks for recent replies on put options I do have more below, but just going over your reply to confirm I get it.
    So for No.1 you say any put options need to be bought at start of contract – and I had actually thought up to end of 2nd week may have been O.K but if you say differently then I’ll have to go with that. The October chart describes a lot with some dates showing off deeper price falls than others. And for my No.4 answer I am understanding that it doesn’t matter where in a s/ways price channel I sell ITM options, as you say it is all to do with what the chart technicals look like – I hope this is what I am thinking(?) (but tell me if I am wrong on all this will you please!)

    Now to quiz you a bit more mainly on put options:-
    1. If after selling OTM options on most shares in a portfolio the S&P500 chart starts looking bearish, then couldn’t we buy put options on shares – as these didn’t have ITM options sold on them?
    2. What about if S&P500 has gone up a fair bit and is now channelling s/ways,- wouldn’t this be probably the most ideal time to buy them – if there was ever to be a best time?(this is actually what a broker said on some seminar DVD I watched)?
    3. And when it comes to picking something to trade if it came down to a decision, then would you say it would be better for me to pick a stock with Mixed technicals but a great return, or an ETF that had a lower return but better Positive technicals?(I think I would probably pick the ETF in this situation because of lower potential risk.)?
    Thanks for the help.

    • Alan Ellman November 19, 2014 12:30 pm #

      Adrian,

      1- Think of buying a protective put as buying insurance, like car insurance for example. Once you buy a car (stock) when should you be insured? At the time of the purchase or 2 weeks later. If your trading style is to have downside protection for a covered call trade then why not be protected for the entire contract?

      2- Price charts are extremely important tools but not the only ones that should dictate our trading decisions. If a stock price is channeling sideways, moving averages are not as useful. In a volatile or bear market I would lean to ITM strikes when a chart is not in a trend. However, in a strong bull market, I may use OTM strikes even for a stock price consolidating. Personal risk tolerance also plays a role. When in doubt, use an ITM strike and opt for the more conservative approach.

      (As my team and I pack for our trip to Las Vegas for our Money Show presentation, I have made a note to re-visit your other questions when I return).

      Alan

    • Alan Ellman November 24, 2014 10:18 am #

      Adrian,

      Regarding your “put” Qs:

      1- When we sell OTM puts we are selling the buyer the right to sell their shares to us. We do not necessarily own those shares to do this unless we are okay with possibly owning more shares. Please advise if am understanding this question correctly.

      2- If the S&P (or any stock or ETF) is trending sideways, moving averages are rendered weak indicators. One would buy puts as an insurance policy against a downturn but an upturn is equally as likely. I also look at the VIX, economic reports and chart technical of the underlying security. I do not hang my hat on only the chart of the S&P 500, although I do recognize it as an important factor to consider.

      3- A stock with mixed technicals is more aggressive than an ETF with better technicals. My decision is based on overall market assessment and personal risk tolerance. For example, I would opt for the stock in my accounts and for the ETF in my mother’s.

      Alan

  5. Keith November 18, 2014 1:29 pm #

    Alan,

    I have a question related to annual returns…

    I calculated roughly from the time I started to do covered call trading till now (about one year), my overall return is about 17% annually (from $82k to $96k account value). Is that good or bad? I was thinking if we do each trade averaging 2-4% monthly, I should be getting at least 25% annually return?

    Thank you.

    Keith

    • Alan Ellman November 19, 2014 12:47 pm #

      Keith,

      You should be very proud of your accomplishment of generating a 17% annualized return. You beat the market and you are still relatively new using this strategy. If you aren’t going to pat yourself on the back for a job well done then I will…CONGRATULATIONS!!!

      Alan

  6. Lin November 19, 2014 3:34 pm #

    Alan,

    If the stock we bought is keep going up, which way is better to do the rolling out and up

    1. wait as close to the expiration Friday as possible

    or

    2. do the rolling out and up (buy to close and sell higher strike the next month) as soon as the market value is over the strike price?

    or

    3. do rolling up (buy to close and sell higher strike the same month)?

    any guideline for above three scenarios?


    thank you

    Lin

    • Alan Ellman November 19, 2014 3:43 pm #

      Lin,

      The strategy that will benefit us most when share price rises significantly is the mid-contract unwind exit strategy (detailed in pages 264 – 271 of the Complete Encyclopedia….). This is where the entire position is closed as time value approaches zero.

      When we roll out or out-and-up, we wait as expiration approaches because the near term option premium will have little time value left and our option debit for buying back the option will be minimal from a time value perspective. The next month premium is not impacted as much as the near term option. due to the nature of theta for near-the-money strikes.

      I will rarely roll up in the same month because we are paying dollar-for-dollar of intrinsic value and then depending on continued share appreciation to benefit…too risky.

      To sum up: Consider the mid-contract unwind in the middle of a contract and rolling strategies as expiration approaches.

      Alan

  7. Alan Ellman November 19, 2014 5:38 pm #

    Premium members:

    This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options as well as the implied volatility of all eligible candidates.

    For your convenience, here is the link to login to the premium site:

    http://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    http://www.thebluecollarinvestor.com/membership.shtml

    I hope to see as many BCIers as possible this Friday @ Caesar’s Palace Las Vegas, Nevada.

    Alan and the BCI team

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  1. Put-Call Parity and Synthetic Trades: Understanding Option Pricing | The Blue Collar Investor - September 19, 2015

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