On one hand, market analysts often argue that interest rate increases have an adverse impact on the equity markets because money becomes more expensive to borrow, thereby creating a disincentive for margin traders to borrow and trade equities. On the other hand, conventional wisdom tells us that equity and bond markets tend to move in opposite directions most of the time, which leads to rising equity markets as interest rates increase.
It's difficult to know which is correct, because like many historical relationships, each may be accurate at different times and under different circumstances. In fact it often seems that the two markets operate completely independent of each other and that neither of these old relationships applies any longer.
In either case, now that the Federal Open Market Committee (FOMC) has finally hiked the federal funds target interest rate (the rate banks charge each other for overnight loans) for the first time in 10 years (on 12/16/2015), it seems likely that if the economy continues to improve, further increases will occur in 2016.
Since the fed funds rate had been at virtually zero for eight years, option strategies intended to take advantage of increasing rates have been mostly irrelevant. However, if the anticipated rate increases do come to pass, it might be useful to know what your "options" are.
Option pricing review
First, let's review how the price of an option is affected by interest rates. To understand this concept you need to have a basic understanding of options Greeks. The Greek that relates to interest rates is called Rho. Essentially, Rho estimates how much the price of an option should rise or fall if the “risk-free” interest rate increases or decreases by 1% (of course, a 1% change in interest rates is quite substantial).
The most recently auctioned 90-day Treasury bill is often used as a proxy for the risk-free interest rate. You can obtain a quote on this rate at Schwab using the symbol $IRX, and then moving the decimal point one position to the left. For example, the current quote on the $IRX is 2.13, which means the 90-day T-Bill interest rate is actually 0.213%.
As shown below, $IRX is the rate used by many option pricing models including the Trade & Probability Calculator tool available in the StreetSmart Edge® trading platform.
Interest rate index: $IRX
Source: StreetSmart Edge
How Rho affects options:
- Call options have positive Rho, so as interest rates increase, call options tend to increase slightly in price, all else being equal.
- Put options have negative Rho, so as interest rates increase, put options tend to decrease slightly in price, all else being equal.
- Of all the variables that affect the price of an option, Rho is one of the least important. However, it should not be completely ignored in a rising or falling interest rate environment.
- Long-Term Equity AnticiPation Securities® (LEAPS®) options, which might expire up to three years in the future, are far more sensitive to changes in interest rates than are shorter-term options, primarily because rates can change a lot during a three-year time period.
The simplest way to explain why interest rates affect the value of options is to think of at-the-money call options as a substitute for a long stock position and at-the-money put options as a substitute for a short stock position. While the profit and loss characteristics are not identical, they are similar enough to help illustrate how the opportunity cost impacts the value of the options in different interest rate environments.
Keep in mind that it is not always appropriate for investors to use option strategies as substitutes for stock trading strategies, as stocks do not expire and may pay dividends. Option strategies always have a limited life span and do not pay dividends or have voting rights.
Call option example
If you buy 100 shares of XYZ at $100 per share, the cost will be $10,000 + commissions. While the $10,000 is invested in XYZ, it cannot be used for any other purpose. Instead of buying 100 shares of XYZ you could have decided to purchase two at-the-money call options expiring in six months at a price of $5 per contract. Since at-the-money call options typically have a Delta close to .50 (which means they should move about $0.50 for the next $1.00 move in the stock), initially the profit and loss characteristics of these two call options are expected to be very similar to 100 shares of XYZ stock.
Note that the regular commission charge for most stock trades at Schwab is $8.95 but the commission charge to purchase 2 option contracts is $10.45 ($8.95 + $0.75 per option contract) so commission costs are slightly higher for option trades.
Since the total cost of the stock trade is $10,008.95 but the cost of the options trade is only $1,010.45 [($5 x 2 contracts x 100) + $10.45 online commission], the $8,998.50 that you did not spend on XYZ stock could be invested in a US Treasury bill or remain in a money market account and earn six months dividends or interest. Using a simple interest calculation, if the Treasury interest rate is 1%, this $8,998.50 will earn about $45 [.01 x 8998.50 x (182/365)] and if the Treasury rate is 5%, it is expected to earn about $225 [.05 x 8998.50 x (182/365)].
In this scenario, you can see how in a higher interest rate environment, the opportunity cost of buying the stock (versus buying call options) is quite a bit higher than during a low interest rate environment. It is primarily for this reason that the option pricing model includes an interest rate component. As interest rates rise, buying calls (as opposed to buying stock) becomes a little more attractive, and that drives the price of call options a little higher.
Put option example
Instead of short selling 200 shares of XYZ, you could purchase four at-the-money put options expiring in six months at a price of $4.50 per contract + commissions. Since at-the-money put options typically have a Delta close to -.50, initially the profit and loss characteristics of these four put options will be very similar to 200 short shares of XYZ stock.
Since the cost of the options trade is $1,811.95 [($4.50 x 4 x 100) + $11.95 online commissions], it leaves only $8,188.05 on which you can earn interest. If the US Treasury bill interest rate is 1%, this $8,188.05 will earn about $41 [.01 x 8,188.05 x (182/365)] and if the Treasury rate is 5% it will earn about $204 [.05 x 8,188.05 x (182/365)].
In this scenario, you can see how the opportunity cost of buying long put options (versus selling stock short) is greater in a high interest rate environment than in a low interest rate environment. While interest rates have less of an impact on puts than on calls, it's important for the option pricing model to take this into account by including an interest rate component. As interest rates rise, buying puts (as opposed to selling stock short) becomes a little less attractive, and that drives the price of put options lower.
As shown below, you can also visualize the effects of Rho by using Theoretical view on the options chain in StreetSmart Edge and setting the underlying stock price equal to a strike price that is very close to the money. Then compare the price of the at-the-money call and the at-the-money put of the same expiration. In the snapshot below, notice that when the underlying price of the example stock1 (IBM) is set to 135, the theoretical value of the 01/15/2016 135 calls is 3.18, while the theoretical value of the 01/15/2016 135 puts is only 3.06. The difference is relatively insignificant in a very low interest rate environment, but it will increase as interest rates rise.
The effects of Rho
Source: StreetSmart Edge
Using this tool, you could estimate that increasing the interest rate (in the green box) by 1% (to 1.213%) would increase the value of the calls by about $0.03 and reduce the value of the puts by about $0.04. While you may not consider this a significant change in price, consider that the fed funds rate in mid-2007 averaged about 5.25%, which would change the prices of the above call and put options to about $3.43 and $2.77 respectively. Of course, an increase of this amount is unlikely during the course of a year, but it could easily happen (and has before) over a period of three years, which is more than enough time to dramatically affect the price of LEAPs options.
In recent years, many ETFs and ETNs, collectively known as exchange-traded products (ETPs) have been introduced that are tied to various segments of the bond market. You can find these products using the ETF screener available at Schwab.com > Research > ETFs > Screener.
Using the ETF screener, you can search specifically for ETPs that are tied to various bonds or interest rates. Since a wide variety of choices are available (long-term bonds, intermediate-term bonds, short-term bonds, high-yield bonds, emerging markets, etc.), just remember the basic rule that the price of a given bond and the interest rate on that bond are inversely correlated.
Even though some ETPs are difficult to sell short, with such a wide variety of products, you can take a position that is either long or short either bonds or interest rates. With this in mind, here are some guidelines:
- Long a bond ETP = Short the interest rate on the underlying bond(s).
Some examples include: TLT, JNK, HYG.
- Short a bond ETP = Long the interest rate on the underlying bond(s).
Now that you know how interest rates can affect options and you know which products are tied to bonds and interest rates, you can combine the two items to formulate a strategy that might perform well if you think interest rates will increase. Here are some general guidelines to help you choose.
Expect rising interest rates (effective choices)
Expect rising interest rates (less effective choices)
- Long puts on a bond ETP
- Bearish put spread on a bond ETP
- If interest rates rise, the long puts should rise.
- But the short puts in the spread should also rise, reducing the profit potential.
- Bearish call spread on a bond ETP
- If interest rates rise, the short calls should drop.
- But the long calls in the spread should also drop, reducing the profit potential.
What to remember
- Not all ETPs trade options and some have very low liquidity.
- Use extra caution when trading low-volume ETPs or those with illiquid options.
- To profit on most option trades, you will usually need to be right about the direction of the underlying ETP, the magnitude it moves in that direction, and also how long it takes to make the move. Occasionally, you can be profitable if you are right on two of these three items.