While most options traders focus on delta, theta, and vega, interest rates play an important role in options pricing that is often overlooked. Understanding how rates affect your options positions can give you an edge, especially during periods of significant rate changes. This guide explains the relationship between interest rates and options.
How Interest Rates Affect Options
Interest rates influence options pricing through the concept of carrying cost. When you buy a call option instead of buying stock, you can invest the money you did not spend on shares. Higher interest rates increase this benefit, making calls more valuable.
The basic relationship: Higher interest rates increase call option values and decrease put option values. Lower interest rates have the opposite effect. This relationship is captured by the Greek letter Rho.
Understanding Rho
Rho measures how much an option's price changes for a 1% change in interest rates. It is typically the least discussed Greek because interest rates usually change slowly, but it matters more than many traders realize.
Call Options
Calls have positive Rho. A call option with Rho of 0.05 gains $0.05 in value for every 1% increase in interest rates.
Put Options
Puts have negative Rho. A put option with Rho of -0.05 loses $0.05 in value for every 1% increase in interest rates.
Example: Rate Impact on Options
The Fed raises rates by 0.50%:
- SPY $450 call with Rho 0.08: Gains approximately $0.04
- SPY $450 put with Rho -0.06: Loses approximately $0.03
- LEAPS call with Rho 0.25: Gains approximately $0.125
Long-dated options are much more sensitive to rate changes than short-dated options.
Factors Affecting Rate Sensitivity
Time to Expiration
Longer-dated options have higher Rho. The rate impact compounds over time, making LEAPS (Long-Term Equity Anticipation Securities) much more sensitive to rate changes than weekly options.
Strike Price
In-the-money options have higher Rho than out-of-the-money options because they are more like owning (or shorting) the underlying stock.
Option Moneyness
Deep in-the-money calls behave almost like stock and are most affected by rates. Far out-of-the-money options have minimal rate sensitivity.
Rate Changes and Options Strategies
Rising Rate Environment
When rates are rising, consider these adjustments:
- Long calls benefit: Slight tailwind for call buyers
- Short puts benefit: Puts lose value, helping put sellers
- LEAPS calls: Most positively affected by rising rates
- Put spreads: May slightly underperform call spreads
Falling Rate Environment
When rates are falling, consider these adjustments:
- Long puts benefit: Puts gain value from rate cuts
- Short calls benefit: Calls lose value, helping call sellers
- LEAPS puts: Most positively affected by falling rates
- Protective puts: Cost less in lower rate environment
Practical perspective: While Rho effects are real, they are usually small compared to delta and theta impacts for short-dated options. Rho becomes significant mainly for LEAPS and during periods of rapid rate changes.
Rate Impact on Popular Strategies
Covered Calls
Rising rates slightly benefit covered call writers because the short call loses value (lower opportunity cost of holding shares).
Cash-Secured Puts
Rising rates increase the opportunity cost of cash tied up for put selling, but also slightly reduce put prices. Net effect is usually modest.
LEAPS Calls
Long-term call buyers benefit most from rising rates. A 2-year LEAPS call can gain 5-10% in value from a 1% rate increase, separate from any move in the underlying.
Calendar Spreads
Rate changes can affect calendar spreads because the front-month and back-month options have different Rho values. Rising rates may slightly favor front-month options.
Example: LEAPS Strategy
You are bullish on a stock and considering LEAPS calls:
- Rates have risen 3% over the past year
- Your 2-year LEAPS call has benefited from this rate rise
- If rates are expected to fall, the rate tailwind reverses
- Consider this when comparing LEAPS to shorter-dated options
Dividend Impact Connection
Interest rates and dividends interact in options pricing:
- Higher rates reduce present value of future dividends
- This affects put-call parity calculations
- Dividend-paying stocks show modified rate sensitivities
- Ex-dividend effects compound with rate considerations
Trading Around Fed Decisions
FOMC meetings that change rates can affect options in several ways:
Pre-Announcement
Implied volatility typically rises before Fed meetings, affecting all Greeks. Rate expectations are already partially priced into options.
Rate Decision
Surprise rate changes have the largest impact. Expected changes are already priced in. The shock from unexpected moves affects both Rho and broader market volatility.
Post-Announcement
Volatility often collapses after Fed announcements (the "volatility crush"). Rate effects are absorbed over the following days.
Practical Considerations
- Short-term traders: Rho effects are usually negligible for weekly or monthly options
- LEAPS traders: Consider rate direction when choosing strike and expiration
- Spread traders: Different Rho exposure on legs creates rate-based P&L
- Hedgers: Long-term protective puts cost more in high-rate environments
- Income traders: Rising rates slightly favor premium sellers
Rate Impact vs Other Greeks
To put Rho in perspective with other Greeks:
- Delta: Typically 10-100x more impactful than Rho
- Theta: Usually 5-50x more impactful than Rho
- Vega: Often 5-20x more impactful than Rho
- Rho: Most significant for LEAPS and in rapidly changing rate environments
Track Your Options Performance
Pro Trader Dashboard helps you monitor all your options positions and analyze what factors are driving your P&L. Understand how rates, volatility, and time decay affect your trades.
Summary
Interest rates affect options pricing through Rho, with higher rates benefiting calls and hurting puts. While the effect is small for short-dated options, it becomes significant for LEAPS and during periods of rapid rate changes. Understanding rate sensitivity helps you make more informed decisions about option expiration selection and strategy choice. Most importantly, consider the rate environment when trading long-dated options where Rho effects can meaningfully impact your returns.
Ready to learn more? Check out our guides on yield curve as an indicator and credit spread trading.