Effect of Interest Rates on Options

What is the effect of interest rates on options? How does interest rates affect call options and put options?

Effect of Interest Rates on Options - Introduction

Oh no! The Feds are raising / cutting interest rates! What effect will that have on my options?

Options is an extremely complex financial instrument when it comes to pricing. Options, being a form of derivative instrument, derives their value from their underlying asset as well as other external factors. Indeed, even though the price movement of the underlying asset is the major determinant of an option's value, options prices can also be affected by many other factors such as dividends, bankruptcies and even interest rates.

This free options trading tutorial shall explore in depth the effect of interest rates on options so that you will better understanding of how options prices behave.

Effect of Interest Rates on Options

Theoretically, when interest rates rises, the premium of Call Options rises and the premium of Put Options falls with all other factors remaining the same. Conversely, when interest rates falls, the premium of Call Options falls and the premium of Put Options rises. However, in real life, all other factors never remain the same. All of the other options greeks affect options prices and most of them affect options prices to a larger degree than interest rate changes so the effect of interest rate changes on options prices is generally negligible in real life trading and the net effect is very often the opposite. As such, options traders should pay more attention to the other price factors unless specifically designing options strategies around interest rate changes.

What Exactly Is Interest Rate?

The first question to really ask is what exactly is this "interest rate" people are talking about? There isn't just one interest rate in the economy; there are interest rates for mortgage loans, interest rates for savings deposits, interest rates for fixed deposits, interest rates for bonds etc. So what exactly is this "interest rate" that influences the price of options?

The first mistake most people make is assuming that it is the interest rate you get from putting your money in a bank that is referred to here. So we frequently get people asking how the price of options are affected if interest rates at the bank rises or falls. That is not the interest rate referred to here in options trading even though all interest rates tend to trend in the same direction over time. The "interest rate" referred to in relation to the prices of options is what is known as the "Risk Free Interest Rate".

Now, what exactly is the "Risk Free Interest Rate"? It is the interest you can get from your money with no risk which also represents the "opportunity cost" of putting your money somewhere else. By investing in another financial instrument such as Options or buying a stock, the stock trader or options trader is foregoing the risk free interest they can get on their money. The specific interest rate used for this purpose in the pricing of options is the interest rate on Treasury Bills or T-Bills. Treasury bills are US government bonds that represents risk free return on your money for the specific time frame covered by the various T-bills. The annualized continuously compounded rate on treasury bills is then taken into consideration in the Black Scholes Model for the calculation of theoretical options price as the options greek "Rho".

Effect of Interest Rates on Call Options

Call options premium rises when interest rate rises and falls when interest rate falls. Apart from the obvious fact that this is due to the interest rate component (Rho) changes in the Black Scholes Options Pricing Model formula, what is the real life justification for such an effect?

There are a few different justifications for the higher call options premium when interest rate rises.

Bear in mind that the risk free interest rate is the opportunity cost of investing in other financial instruments such as stocks or options. The higher the interest rate, the higher the opportunity cost of taking the money out of bonds and into those instruments. When interest rates are high, the opportunity cost of buying stocks becomes higher because investors are losing out more T-bills interest. That makes buying call options instead of the stocks more attractive. By buying call options instead of the stocks, investors can control the same amount of stock profits using just a small fraction of the money it takes to buy the actual stocks. This slightly higher demand for call options theoretically justifies for slightly higher call options premiums, all other factors remaining unchanged (which again is never the case).

Effect of Interest Rates on Call Options Example Assuming AAPL is trading at $500 and 30-day T-bills are at 0.08%. John is holding 100 shares of AAPL in his portfolio worth $50,000. Over time, 30-day T-bills increased to 0.10% and John decides to reallocate the cash he has in AAPL into the safety of the T-bills while maintaining exposure to 100 shares of AAPL. AAPL's 30 days $500 strike price call options are asking at $20. John BUY TO OPEN one contract of call options representing 100 shares for a total of $20 x 100 = $2000 and invests the rest of the $48,000 into 30-day T-bills.

The higher call options premium when interest rate rises is also additional compensation for the loss of additional interest incurred by options writers. When an options writer sell you call options, they need to either have the same amount of stocks in inventory or have cash locked up in their account as margin. Either way, the options writer is denied the right to sell the stocks or reallocate the cash into those higher interest T-bills. This loss of interest by the seller is compensated by a higher options premium to be paid by the buyer of those call options.

Effect of Interest Rates on Put Options

Put options premium falls when interest rates rise and rises when interest rates falls. So, whats the real life justification for such an effect?

Put options are substitutes for shorting shares. When an investor short shares, they get cash in their account which earns them interest. However, when they buy put options in order to speculate to downside, they don't get the extra cash in the bank, hence losing out on interest. This makes buying put options when interest rate rises less attractive than shorting the shares. That lower demand theoretically justifies for the lower put options premium when interest rate rises, all other factors remaining unchanged. Conversely, when interest rate falls, shorting shares becomes less attractive than buying put options as the extra cash won't be making as much interest revenue, hence demand for put options rises along with its premium.

In fact, professional options traders substitute for shorting shares by taking what is known as a "Synthetic Short Stock Position" through the simultaneous purchase of put options and selling of call options. This has the effect of simultaneously increasing premium of put options and driving down premium of call options, thereby reinforcing the effect of rising put options premium and falling call options premium during interest rate cuts.

When you buy put options, the seller of those put options usually have a short position in the underlying stock which gave the seller cash earning interest in the account at the risk free interest rate. As such, when interest rate rises, put options premium adjusts downwards to neutralize additional gains by the seller so that it remains a fair trade between the buyer and the seller with neither side having a definite advantage right from the start.

Effect of Interest Rates on Options In Real Life Trading

As interest rate changes effect the extrinsic value of an option and not the intrinsic value, it affects options with significant amounts of extrinsic value more. Such options are near the money options as well as options with significant time to expiration as they contain more extrinsic value than deep in the money or far out of the money options with little time to expiration (read more about Options Moneyness).

However, in real life trading, since interest rates rise so slowly and so insignificantly, its effects are buried by price fluctuations caused by the other options greeks. In fact, implied volatility (Vega) affects extrinsic value much more than interest rates can and it changes almost every single second an option is traded.

In real life trading, interest rate changes affects stock prices much more than they affect options prices. When interest rates rises, stocks come under heavy pressure and would usually drop. Such a drop would take the price of call options down more than the gain in "Rho" can compensate and appreciate the price of put options. When interest rates cut, stocks usually rally and push up the price of call options more than the loss in "Rho" can offset and depreciate the price of put options. As such, taking interest rates into consideration for options pricing remains more of a way of ensuring completeness of the options pricing formula and could come into play in extreme conditions but under normal trading conditions, interest rates has little to no observable effect on options prices. As such, options traders, especially beginners, should not be overly concerned with the effect of interest rate changes on options pricing unless specifically designing options strategies around interest rate changes.

Most Related Reading: Effect of Dividends on Options

Learn my proprietary system of short and neutral delta trading that produces 5% to 8% monthly income under every market conditions, even strong trending markets!