Did you know that the value of your options can fluctuate with interest rates? If not, then you should familiarize yourself with Rho.
Rho is one of “the Greeks,” or statistical measurements that help you evaluate options contracts.
Specifically, Rho measures how much an options price will change based on a change in the interest rates.
Although that may seem like a simple concept, there’s quite a bit to unpack in that last statement. We’ll cover it all in this guide.
Why? It’s all about how interest rates affect the supply and demand of options.
- As interest rates increase, call options increase in price and put options decrease in price.
- As interest rates decrease, put options increase in price and call options decrease in price.
- Let’s look at an example that explains why that happens.
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Suppose you’re an active trader. You see that Skechers (NYSE: SKX) is trading at $32 per share and you believe it’s poised to pop.
At this point, you can either buy shares of SKX or you can buy a call option.
The advantage of a call option is that it’s cheaper but you can earn the same return in dollars. However, unlike stocks, the option has an expiration date and it’s subject to time-decay.
If you bought shares of the stock, though, you’d have to pay a lot more money. It would cost you $3,200 to buy 100 shares while it would only cost $130 to buy next month’s at-the-money call option.
So what should you do?
You check current interest rates. You see that they’re low.
As a result, you would earn very little return by keeping cash parked in your brokerage. Also, you would pay little in interest on the money you borrow to buy 100 shares Skechers stock.
So you decide to buy the stock outright instead of buying the call option.
Do you see what happened there? The interest rates affected your investment decision.
In this case, you were less likely to buy a call option because of low interest rates.
Now multiply your sentiment times thousands or tens of thousands of traders all over the country. If they all think like you, they’ll buy shares of stock instead of a call option.
And what happens when demand for a call option drops? Basic economics teaches us that the price will drop as well.