A year ago, the Federal Reserve's discount rate was near 0%. Today, it is set to a range of 4.5% to 4.75%. Rates have risen quickly, and most expect the US central bank isn't done raising rates yet.
When it comes to trading options, what might rising rates do to options prices? "Interest rates have a small, but measurable effect on options premiums," according to the Options Industry Council. The extent and direction of that effect depends on the type of option, your strategy, and time frame. While interest rates aren't a primary factor to think about when picking your options strategy, interest rate moves can have some impact—particularly for longer-term options.
Why do interest rates influence options?
Rates can influence the price of an options contract, along with the underlying company and stock that options are based on. The combined effect is an impact on options premiums (the price a buyer pays to purchase an options contract). Holding all else equal, call option premiums generally rise when interest rates increase, and put option premiums generally decrease when interest rates increase.
An example may help illustrate why rates affect options premiums. Suppose you have $50,000 to invest, and you were deciding between buying 500 shares of a $100 stock and buying 5 call options contracts (one contract controls 100 shares of the underlying stock) on that same stock for $10 each. The stock purchase would cost $50,000, while the options purchase would cost $5,000 to control the same number of shares of the stock. If you bought the options, you would have $45,000 available to invest.*
Now, assume the prevailing short-term government bond rate was 1%. This means you could hypothetically earn $450 per year using the $45,000 ($45,000 x 0.01%). At 2% interest, you could earn $900 ($45,000 x 0.02%), and so on. Simply put, in a rising-rate environment, the interest you can earn at higher rates makes the opportunity cost of buying the stock less attractive versus buying the call options, holding all else equal.
For puts, the impact of interest-rate changes is the opposite as that of calls. This should be intuitive since a put (which grants the owner the right, but not the obligation, to sell the underlying asset) is the opposite of a call (which grants the owner the right, but not the obligation, to buy the underlying asset).
Buying a put establishes a position similar, but not identical, to shorting a stock. (When you short a stock, you are hoping that the price will decrease in order to profit, which is the same expectation for buying a put). As rates rise, buying puts can become less attractive compared with shorting stocks because an investor could earn interest on the short position. Higher rates mean an investor can earn more interest on the short position than purchasing a put, and that should drive the price of put options lower.
Rates and LEAPS
In practice, the actual impact of rising rates on most options tends to be minimal because, during the life of most options with expirations dates that are just one or a few months out, any change in interest rates will typically be relatively small during the life of the options contract.
While shorter-term options, which comprise the overwhelming majority of the options market, experience little impact of rising rates, long-term equity anticipation securities (LEAPS) may be impacted to a greater extent.
LEAPS are call or put options that have expiration dates as far out as several years (compared with ordinary options, which have much shorter expiration dates). LEAPS can expire one or more years into the future, and so a significant move in interest rates over that time is more possible. As a result, LEAPS can be more sensitive to changes in interest rates than options with shorter expiration dates.
Rates and rho
One tool in particular that can help you assess the impact of rate changes is the options Greek rho. Options Greeks are mathematical calculations used to determine the effect of various factors on the price of an options contract. Rho measures the amount the price of an option will change for every 1% change in interest rates.
In practice, rho is not used as frequently as other widely used Greeks—like delta and gamma—because the relationship between interest rates and options value is not as significant as other factors (like sensitivity to changes in the underlying asset price or time until expiration). However, if rates were expected to change dramatically during the life of an options contract, you might want to consider incorporating rho into your analysis. On Fidelity.com, you can find rho in the options chain by going to Settings and adding it. You can also assess the impact of rho in the Profit/Loss Calculator on Fidelity.com.
So, what does all this mean? All else equal, buyers of call options may be paying marginally higher prices for call options and marginally lower prices for put options relative to a year ago. Alternatively, sellers may be receiving marginally higher prices for call options and marginally lower prices for put options. LEAPS premiums may have experienced more noticeable moves.
Of course, the impact of interest rates is not nearly as significant as other factors that drive options prices. Nevertheless, incorporating the potential impact using rho and any other tools you find useful may help optimize your options strategy.