By Chris Ebert

5.25 percent interestIt may come as a surprise to many younger option traders to learn that interest rates do affect option premiums. More seasoned traders, particularly those over 50, likely recall a time when double-digit interest was common. Indeed, there was a period as recently as the early 1980s when U.S. 10-year Treasury-Bills (T-Bills) offered an annual rate of 15% or so.

Now that the Federal Reserve is contemplating raising interest rates sometime in late 2015 into 2016 and beyond, it is important for option traders to understand the potential effects. Even though it’s not likely we’ll see offers of 5.25% interest on savings accounts appearing in the local newspaper anytime soon, option traders could still notice changes.

Rising rates affect borrowers, who often must pay rates that are higher than the 10-year T-Bill rate for mortgage loans, auto loans and credit cards. The increase also has an impact on savers, since banks and other institutions tend to offer higher rates on savings, checking and money-market accounts when benchmark rates, such as the rate on T-Bills, go up.

Many types of interest-bearing accounts for savers carry some type of insurance, for example FDIC insurance. Insurance makes most typical savings accounts essentially risk free – the only risk being a total collapse of the government insurance program. Thus, such accounts tend to be considered as risk-free as T-Bills, which are backed by the government and its track record of payments on those Bills.

The ability to move funds from the stock market, which is risky by its very nature, to a risk-free investment is important, but generally is of very little concern to an option trader when interest rates are extremely low. Extremely low rates, such as those in place since the Federal Reserve lowered rates in 2008 to combat the Financial Crisis, are unattractive to folks who own stock.

For example, someone who owns $10,000 of stock for a year would have earned $100 in interest if those funds were instead placed in a risk-free account that paid a 1% annual interest rate. In a way, the stock owner is forfeiting $100 in interest in order to own retain ownership of the stock. Although $100 is nothing to sneeze at, it’s not a huge cost if there is a potential to earn several hundreds of dollars by owning the stock through a period of gains in the share price.

Rising Interest Rates Affect Stock Owners

When interest rates rise, however, the ability to earn a significant amount of interest takes on a whole new meaning. Even at a modest 5% rate – by long-term historical standards a risk-free rate of 5% is indeed modest – a trader who owns $10,000 worth of stock would forfeit $500 worth of interest in a year’s time. In other words, the stock owner would need to earn a 5% annual return on the stock, all the while running the risk losing money if the stock price falls, just to keep pace with what he could have earned in a savings account without risking a dime.

It is perfectly understandable, therefore, when interest rates rise that stock traders would look for ways to retain their stock positions using much less capital, thus leaving the remainder of the capital to earn interest.federal reserve building

One way to buy stock with less capital is to trade on margin. Typically, a trader can put up half the capital and borrow the other half, on margin, from a broker. Since only half the normal capital is required to buy the shares of stock, the other half can remain as a cash balance and earn interest. There’s just one problem, when interest rates go up, the cost of borrowing rises as well as the cost of saving. Interest rates paid on margin rise in tandem with interest rates received on cash balances. So, any benefit from earning a higher interest rate on cash balances tends to be offset by the cost of borrowing funds on margin.

Another way to take stock positions with less capital is to use stock options. It is not uncommon for option contracts to cost as little as 20%, or in some cases 10% of the capital required to open the equivalent stock trade. For example, it may be possible to buy an option contract for $2,000 that is equivalent to owning $10,000 worth of stock. In that example, the remaining $8,000 could be set aside in a cash account to earn interest. As interest rates rise, such interest-earning ability has obvious advantages.

The simplest method for replacing stock positions with options is the Call option. A Call option is a contract that gives the option buyer the right to purchase a stock at a specified price. A trader can buy a standard Call option instead of buying 100 shares of stock, and the Call option will tend to return profits when the stock price rises. For example, if a trader buys a Call option and obtains the right to buy a stock at $100 per share, that trader can profit if the stock price rises to $120 because the right to purchase the stock at $100 is quite valuable when the stock is trading at $120.

Rising Rates make Call Options Attractive

Since Call options tend to become more valuable when stock prices rise, buying Call options can serve as a suitable replacement for buying stocks. Options are quite complicated instruments, so not all Call options are suitable as replacements for stock ownership. But, as a general rule buying a Call option will provide a position that is equivalent or at least somewhat equivalent to buying stock, but the Call option will always cost less that the stock.

It should come as no surprise, therefore, that when interest rates rise, demand for Call options also rises; and when demand rises, the cost of Call options rises as well. Folks who want to keep cash balances as high as possible during periods of high interest rates are more willing to pay a higher premium for Call options than they otherwise would be inclined to pay for those same Call options during a period of low interest rates. Thus, higher interest rates drive Call option premiums higher because more traders are likely to desire to buy Call options in lieu of buying stock than when interest rates are lower, and they are also willing to pay more for the privilege, all as a means of conserving trading capital and keeping cash where it can earn interest.

The effect of interest rates on option premiums is known as Rho. Call option premiums tend to increase when interest rates rise, thus Call options are said to exhibit positive Rho. For example, if a Call option has a Rho of +1, the premium of that option will increase $1 for every 1% increase in risk-free interest rates.

Rho Calls and Puts

Put options behave a little differently. One of the many uses of Put options is for a stock owner to lock in profits without actually selling the shares of stock. As with all option contracts, Put options are complex, so not all Put options behave the same. In general, however, since a Put option guarantees the buyer of the option the right to sell a stock at a specified price, buying a Put option is equivalent or somewhat equivalent to selling stock.

When a trader owns 100 shares of stock and buys a standard Put option the trade is known as a Protective Put. A standard Put option guarantees a minimum sales price for 100 shares of stock. Thus it is possible to effectively guarantee the sale of 100 shares of stock, at some pre-determined future date, but without actually giving up ownership of any shares at the present time. Protective Put trades, though not the only use for Put options, are quite common. The popularity of Protective Puts makes them one of the major drivers of Put option pricing.

Rising Rates make Protective Puts Less Attractive

Owners of stock miss out on collecting interest on the capital that is devoted to those shares of stock. When interest rates rise, those same owners miss out on larger sums of interest. Only by selling the stock can a trader move the funds into a cash account and collect interest on the cash balance. For example, if a trader owns $10,000 worth of stock and the rate paid on T-Bills is 5% per year, then the trader is potentially missing out on $500 per year in interest by owning the stock as compared to owning $10,000 in T-Bills.

A trader who buys a Protective Put option in lieu of selling a stock position does not free up any funds. Thus, there are no sale proceeds to earn interest when buying a Protective Put option as a replacement for selling stock. For example, if a trader sells $10,000 worth of stock, perhaps to take profits on that stock, the $10,000 in proceeds from the sale can be moved to a cash account and earn interest. If the trader instead retains the stock and buys a Put option to protect the profits, there is no $10,000 in proceeds to move to cash, and no interest to be earned.

It should come as no surprise then, that demand for Put options tends to decrease when interest rates rise. Folks who, during periods of low interest rates, would otherwise be willing to pay a higher price for Put options rather than sell their stock positions, tend to be more inclined to sell their stocks and move the proceeds of the sale into interest-bearing cash accounts during periods of high interest rates. Thus, higher interest rates drive Put option premiums lower.

Summary

The effect of interest rates on Put options is generally the opposite of the effect on Call options. Higher interest rates correlate with higher Call option premiums. Higher interest rates correlate with lower Put option premiums. Call options have positive Rho. Put options have negative Rho. For example, a Put option with a Rho of -1 will tend to experience a decrease in premium of $1 for every 1% increase in the risk-free interest rates.supply and demand

Buying a Call option can make sense for a trader, instead of buying stock, during a high interest rate environment. That makes Call options more attractive when interest rates rise, which causes an overall increase in Call option premiums. During high interest environments it can be better to own inexpensive Call options than to own the more costly shares of stock, and to earn interest on the cash saved by choosing the Call options. On the other hand, Put options become less attractive for stock owners looking to lock in profits because selling the stock frees up cash that can then earn interest whereas buying Put options does not free up cash.

The above analysis only touches the basics of the relationship between interest rates and option premiums. There are many other factors to consider, such as the different effects of interest rates depending on the strike prices of the options, and the tendency for more distant expiration dates of the options to have a greater effect than nearer expiration dates. The effect of interest rates also varies with changes in volatility. A discussion of all those additional effects could be quite lengthy.

For the average option trader, it is sufficient to recognize that should interest rates broadly increase, Call option premiums will tend to go up and Put option premiums will tend to go down. It is also important to recognize that the effect of a quarter point increase in the risk-free interest rate would have a relatively small effect on option premiums. Furthermore, other factors can easily overshadow the effect of interest rates – the Rho effect. An widespread increase in implied volatility, e.g. an increase in the VIX, tends to correlate with much larger changes in option premiums than small changes in interest rates. Thus, to option traders, the initial increases in interest rates may seem to be much ado about nothing.

Regardless of the relatively small influence that a single increase of a quarter point might have on option premiums in 2015, the effect is cumulative. That is to say, if the Federal Reserve increases rates further in 2016 and beyond, Call options would tend to become increasingly expensive with each increase in the interest rate. Put options would cumulatively become less expensive. For example, Call options would tend to cost much more if T-Bills were returning 5% a year than they would at 3% a year, and more at 3% a year than at 2% a year. It’s just something for option traders to look forward to, and something that has likely been out of traders’ minds for many years.

The preceding is a post by Christopher Ebert, Chief Options Strategist at Astrology Traders (which offers subscribers unique stock-trading perspectives and options education) and co-author of the popular option trading book “Show Me Your Options!” Chris uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca

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