How These Interest Rate Hikes Impact Options Traders

Breaking down the impact of interest rate hikes

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    Interest rate hikes can have a significant impact on the pricing of options. Therefore, understanding how interest rate changes can impact option prices is important, as it can affect trading decisions and overall profitability.

    How Interest Rates Affect Call and Put Option Prices

    Interest rates directly impact the pricing of call and put options. The value of an option is determined by several factors, including the underlying asset price, time to expiry, volatility, dividend yield, and interest rates.

    When interest rates rise, the cost of borrowing money to buy stock on margin increases. For example, if you want to buy $10,000 worth of stock on margin, the cost to use margin is much higher when interest rates are at 5% vs. 2%. 

    Therefore, a trader may look to buy a call option to avoid this increased margin interest. For this reason, the pricing of call options will rise when interest rates are hiked. 

    What Happens to Call Options When Interest Rates Rise?

    When interest rates rise, call options increase due to the higher cost of buying stock on margin. It is cheaper to purchase a call option than to purchase 100 shares, making it more attractive to buy call options when interest rates are high.

    However, it is important to understand that buying a call option may be riskier than buying shares of stock on margin. While you will have to pay more money to own a stock with margin with higher interest rates, there is still no expiration date like call options have. 

    Interest Advantage in Call Options

    The options market reacts to interest rates, causing call options to increase in value. Instead of buying $10,000 worth of stock on margin, a trader can purchase a call option to benefit from the same upside with much less capital, say $1,500. 

    The saved $8,500 can be put into a risk-free asset such as a T-bill to generate interest, allowing the trader to benefit from the potential upside of a stock and generate income with a bond. 

    Due to the traders' ability to generate a risk-free return on this saved capital, the price of call options increases. There is no free lunch in the stock market, so when opportunities like this arise, it will reflect in the price of call options. 

    Interest Disadvantage in Put Options

    When a trader sells a stock short, they are not required to put up the notional cash equivalent, allowing them to generate interest on the leftover capital. For example, if a trader sells short $10,000 worth of stock, they may only have to put up $5,000 worth of margin requirements. 

    The remaining $5,000 can generate interest at a risk-free rate similar to a T-bill. Therefore, selling stock short is more attractive in high interest rate environments when compared to buying put options. 

    If the trader bought puts instead of selling short and paid a premium of $4,000, only $1,000 could generate interest at the risk-free rate. Due to this, put options will decrease in value as interest rates rise. 

    With increased interest rates, shorting stock becomes more profitable than buying puts, as traders can generate interest as a short seller but not as a put buyer. Therefore, put option prices are impacted negatively by increasing interest rates.

    The Rho Greek

    The Rho Greek measures the sensitivity of an option's price to a change in interest rates. It indicates the amount the option price will change for every 1% change in interest rates.

    For a standard option pricing model like Black-Scholes, the Rho Greek is not considered a primary factor in option pricing, as interest rate changes are infrequent and usually small in magnitude (in increments of 0.25%). Other factors like the underlying asset price, time to expiry, volatility, and dividend yield change more frequently and in larger magnitudes, which have a comparatively larger impact on option prices.

    While Rho has a relatively minor impact on option prices compared to other Greeks, like delta, gamma, vega, or theta, it is still an important factor to consider when trading options. Traders need to be aware of the impact of interest rates on option prices and take Rho into account when making trading decisions.

    How do You Profit From Rising Interest Rates?

    Options traders can capitalize on interest rates rising in several ways, including buying call options, selling put options, trading interest rate futures, and buying T-bills in a margin account.

    Buying T-bills in a Margin Account

    When interest rates rise, traders can buy T-bill in a margin account with extremely low margin requirements and still stack options trading on top of it. For example, a trader with a $100,000 account can buy $100,000 worth of T-bills, which only utilizes less than a 10% margin requirement.

    Therefore, the trader can sell options with 90% of their account while generating a risk-free return in the bond market. Since selling options contracts doesn’t requires cash like stock does, the trader will not pay any margin interest. 

    Selling Put Options

    When interest rates rise, the prices of put options decrease. Therefore, if a trader sells put options before rate hikes, they can theoretically generate a profit. Although, interest rates are just one factor that drives profitability when selling puts. 

    Buying Call Options

    Conversely, rising interest rates will cause call option prices to rise, allowing call buyers to generate a profit. Rising interest rates are just one factor to consider when buying call options, so traders should not rely on rates rising alone to generate profit when purchasing calls. 

    Trading Interest Rate Futures

    Traders can also profit from rising interest rates by trading interest rate futures contracts. These contracts allow traders to bet on the direction of interest rates and make a profit if their predictions are correct.

    Which Rate Do You Use for Pricing Options?

    The Black-Scholes options pricing model uses annualized interest rates to determine the price of options. Generally, the one year treasury bond rates are used with the Black-Scholes model. 

    However, it is crucial to ensure you use the annualized Treasury interest rates for your calculations. 

     

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