Option “Greeks” like Delta and Vega are widely followed, but too few traders are following Rho, a measure of interest rate impact. If rates change, so too will option trading.
In a recent conversation between one of my more experienced option students and a less-experienced option trader, the subject of option “Rho” came up. They were discussing whether a long-term view made more sense with a stock or the stock’s LEAP option.
My more experienced student said
"Sometimes I like the stock, but right now, I really like LEAPs because I want the Rho." The student asked what that meant. It’s a great question to which far too few option traders know the answer.
The definition of “Rho” is the amount an option will gain or lose with a one-point increase in interest rates.
Thus, an option that has an Rho of .05 will make .05x100 for every 1% increase in interest rates. The interest rate is usually considered the Fed funds rate, sometimes called the “risk-free rate.”
Like Deltas, calls have a positive Rho and puts have a negative Rho. Like Vega—and actually, this may be even more intuitive—the longer the period of time to expiration, the more Rho the option will have.
Over the past few years, with rates so low, Rho has been the quiet option Greek, the one no one talks about.
But, much like every quiet person, at some point, this thing is going to pop. And if you think this cannot affect the average retail investor, think again!
Most “income” traders are trading short-duration trades like butterflies, calendars, and condors. However, once they are used to trading options on a regular basis, instead of holding stocks, these traders will turn to LEAPs to go short or long a stock.
With their long duration, these LEAPs are very sensitive to changes in interest rates. A holder of a 2013 LEAPs call is in a position to profit even if the stock doesn't rally, as it is extremely sensitive to interest rates.
A put holder, on the other hand, can get their clock cleaned in pretty short order if rates start to rise quickly. For example, a client of mine loves NetApp, Inc. (NTAP) both short and long term. I suggested LEAPs because it gave the student the right duration, and as an added benefit, he might profit from changes in interest rates.
Suppose the trader was deciding between buying an NTAP Jan 2012 $52.50 call for $5.65 versus an NTAP Jan 2013 $52.50 call for $9.00.
Modeling, if on September 25, NTAP is trading at $55 and rates are 1% higher (I know, that’s a stretch), which option will have gained more value or lost less? The answer:
The Jan 2012 call will be worth about $5.35, a loss of $30.
The Jan 2013 call will be worth $9.50 a gain of $50.
This is, of course, an extreme example, but it goes to show the trader how Rho can affect one trade versus another.
One interesting option trade I have on is the ProShares Ultrashort Lehman 20-Year Treasury (TBT), the TBT 2013 calls. With rates low, TBT is cheap, and as rates rise, TBT will gain value and my calls will pick up value from Rho. It’s almost like being triple short interest rates.
Most traders do not pay attention to Rho, or cost of carry at all, however, as rates start to change, so too will options trading.
LEAPs calls may not be nearly as cheap as they are now, while puts will seem like a better bargain. So, like my option mentoring student, if someone says, ‘I like LEAPs calls for the Rho,” you will know what he or she means.
By Mark Sebastian of OptionPit.com
