Rho and Interest Rate Risk: The Forgotten Options Greek

Rho is often called the forgotten Greek because most options traders rarely think about it. For short-dated options in stable interest rate environments, rho is indeed negligible. However, when interest rates are changing rapidly or when trading long-dated options like LEAPS, rho can have a meaningful impact on your positions. This guide will help you understand rho and when it actually matters.

What is Rho?

Rho measures how much an option's price changes when interest rates move by one percentage point. For call options, rho is typically positive (calls gain value when rates rise). For put options, rho is typically negative (puts lose value when rates rise).

Why Interest Rates Affect Options

To understand rho, you need to understand why interest rates affect options prices in the first place. There are two main reasons:

1. The Cost of Carry

When you buy a call option instead of buying stock, you can invest the money you saved in a risk-free asset (like Treasury bills). If interest rates are high, that alternative investment is more attractive, making call options more valuable.

Conversely, puts are an alternative to shorting stock. When you short stock, you receive cash that earns interest. Higher rates make shorting more attractive relative to buying puts, making puts less valuable.

2. Forward Price

Options pricing models use the forward price of the underlying asset, which accounts for interest rates and dividends. Higher interest rates increase the forward price, which benefits calls and hurts puts.

Rho Characteristics

Rho by Time to Expiration

The longer until expiration, the larger the rho. Short-dated weekly options have almost zero rho because interest rates barely matter over a few days. LEAPS with two years until expiration have significant rho.

Rho by Moneyness

In-the-money options have higher rho than out-of-the-money options. Deep in-the-money calls have the highest positive rho, while deep in-the-money puts have the most negative rho.

Calls vs Puts

Call options have positive rho (benefit from higher rates). Put options have negative rho (hurt by higher rates). This asymmetry can matter for portfolio hedging and strategy selection.

When Rho Actually Matters

1. LEAPS Trading

If you trade long-dated options with more than six months to expiration, rho becomes significant. A 1% rate change can move a LEAPS option by 5-10% of its value.

2. Rapidly Changing Rate Environment

When the Federal Reserve is aggressively raising or cutting rates, rho exposure adds up. In 2022-2023, when rates rose from near zero to over 5%, LEAPS traders felt the impact.

3. Large Positions

Even small rho per contract adds up with large position sizes. Market makers and institutional traders carefully monitor their rho exposure.

4. Options on Interest Rate Products

Options on Treasury futures, Eurodollar futures, or other interest rate products have direct and significant rho exposure.

Real-World Impact: The 2022-2023 Rate Cycle

The recent interest rate cycle provides a perfect case study for rho's importance.

Strategies Considering Rho

LEAPS Calls in Rising Rate Environment

If you expect rates to rise and want long stock exposure, LEAPS calls benefit doubly. They give you bullish exposure and the rising rates increase call values via rho.

LEAPS Puts in Rising Rate Environment

Be cautious about long-dated puts when rates are rising. Even if you are correct about the stock declining, rising rates work against your put's value.

Calendar Spreads

When constructing calendar spreads with very different expirations, the rho of the long-dated leg can differ significantly from the short-dated leg, creating unintended rate exposure.

Managing Rho Risk

For LEAPS Traders

• Know your portfolio rho before Fed meetings
• Consider the rate outlook when choosing calls vs puts for long-dated positions
• Use spreads to reduce rho (buying and selling similar-dated options neutralizes some rho)

For Short-Term Traders

If you primarily trade weekly or monthly options, rho is almost always negligible. Focus on delta, gamma, theta, and vega instead. Do not let rho distract you from more important risks.

For Portfolio Managers

If you run a large options portfolio, aggregate your rho across all positions. Sudden Fed announcements can create unexpected gains or losses if your rho exposure is significant.

Rho vs Other Greeks

To put rho in perspective, here is how it compares to other Greeks in terms of daily impact for a typical position:

• Delta: Impacts position daily (stocks move every day)
• Theta: Impacts position daily (time passes every day)
• Gamma: Impacts delta daily, indirect but constant effect
• Vega: Impacts position during volatility changes (frequent but irregular)
• Rho: Impacts position during rate changes (infrequent, often 8 times per year at Fed meetings)

Summary

Rho measures interest rate sensitivity and is often the least important Greek for most traders. However, it becomes significant when trading LEAPS, during periods of rapidly changing rates, or with large portfolios. Calls benefit from rising rates (positive rho) while puts suffer (negative rho). For short-dated options, you can safely ignore rho, but LEAPS traders should always consider the interest rate environment and their rho exposure.

Explore more advanced Greeks with our guides on charm and vanna.