Trading | September 30, 2021

Options Strategies for Rising Interest Rates

Some economists and market analysts believe that interest rate increases have an adverse impact on equity markets. Their reasoning is that money becoming more expensive to borrow creates a disincentive for margin traders to borrow and trade equities. Yet there has often been very little correlation between interest rates and margin debt. Conventional wisdom tells us that equity and bond markets tend to move in opposite directions most of the time, which leads to rising equity markets as interest rates increase. But finding periods when this isn’t the case is not all that difficult.

Like many historical relationships, the opposite may be true at different times and under different circumstances. More often than not, it seems that equity and bond markets operate completely independent of each other and that many of the old relationships between the markets and interest rates no longer apply.

When the global financial crisis forced the Federal Reserve to cut the Fed funds rate to essentially zero back in late 2008, option strategies intended to take advantage of rising interest rates became mostly irrelevant, and they remained so for the next seven years. The Fed began to gradually hike rates again from late 2015 through 2017, but those hikes were quickly unwound when the COVID-19 pandemic hit in early 2020, and they have been essentially at zero ever since. While the Fed has significant control over the short end of the yield curve, a sharp uptick in inflation expectations could cause longer-term rates to rise—which is what happened in early 2021.

Despite a commitment by Federal Reserve Chair Jay Powell to maintain a low interest rate environment for an “indefinite” period of time, by March 2021 interest rates on the 10-Year Treasury Note began to rise, hitting a 14-month high of 1.75%. Since no one knows whether that trend will continue, it might be useful to know what your options are.

Option pricing

First, let’s review how the price of an option is affected by interest rates. To understand this concept, you need to have a basic understanding of option Greeks. Greeks, including Delta, Gamma, Theta, Vega, and Rho, measure the different factors that affect the price of an option contract. They are calculated using a theoretical options pricing model. The Greek that relates to interest rates is Rho. Essentially, Rho estimates how much the price of an option contract should rise or fall if the assumed “risk-free” interest rate increases or decreases by 1% (of course, a 1% change in interest rates is quite substantial).

The most recently auctioned 90-day Treasury bill is often used as a proxy for the risk-free interest rate. You can obtain a quote on this rate at Schwab using the symbol $IRX, then moving the decimal point one digit to the left. For example, if the current quote on the $IRX is 0.15, it means the 90-day T-bill interest rate is 0.015%, or 0.02% when rounded to two decimal places.

As shown below, $IRX is the rate used by many option pricing models, and the Trade & Probability Calculator tool available in the StreetSmart Edge® trading platform.

Interest rate index: $IRX

$IRX rate is shown on the Trade & Probability Calculator tool available in the StreetSmart Edge® trading platform.

Source: StreetSmart Edge®

How Rho affects options

Rho affects options in the following ways:

  • Call options have positive Rho, so as interest rates increase, call options tend to increase slightly in price, all else being equal.
  • Put options have negative Rho, so as interest rates increase, put options tend to decrease slightly in price, all else being equal.
  • Of all the variables that affect the price of an option, Rho is one of the least important. However, it should not be completely ignored in a rising or falling interest rate environment.
  • Long-Term Equity AnticiPation Securities® (LEAPS®) options, which might expire up to three years in the future, are far more sensitive to changes in interest rates than are shorter-term options, primarily because rates can change a lot during a three-year time period.

The simplest way to explain why interest rates affect the value of options is to think of at-the-money call options as a substitute for a long stock position and at-the-money put options as a substitute for a short stock position. While the profit and loss characteristics are not identical, they are similar enough to help illustrate how the opportunity cost impacts the value of the options in different interest rate environments.

Keep in mind that it is not always appropriate for investors to use option strategies as substitutes for stock trading strategies, as stocks do not expire and may pay dividends. Option strategies always have a limited life span and do not pay dividends or have voting rights.  

Call option example

If you buy 100 shares of XYZ at $100 per share, the cost will be $10,000. While the $10,000 is invested in XYZ, it cannot be used for any other purpose. Instead of buying 100 shares of XYZ, you could have decided to purchase two at-the-money call options expiring in six months at a price of $5 per contract. Since at-the-money call options typically have a Delta of somewhere close to 0.50 (which means they should move about $0.50 for the next $1.00 move in the stock), initially the profit and loss characteristics of these two call options are expected to be very similar to 100 shares of XYZ stock. (Note that commission charges for most stock trades at Schwab is $0.00 but the commission charge for option contracts is $0.65 per option contract, so commission costs are slightly higher for option trades.)  

Since the total cost of the stock trade is $10,000 but the cost of the options trade is only $1,001.30 ([$5 x 2 contracts x 100] + $1.30 online commission), the $8,998.70 that you did not spend on XYZ stock could be invested in a US Treasury bill or remain in a money market account and earn six months of dividends or interest. Using a simple interest calculation, if the Treasury interest rate is 0.15%, this $8,998.70 will earn about $6.73 (.0015 x 8,998.70 x [182/365]). In a very low interest rate environment, this might be considered negligible. However, if the Treasury rate was even 1.00%, it would earn about $44.87 (.01 x 8,998.70 x [182/365]), more than six times as much.

In this example, you can see how in a higher interest rate environment, the opportunity cost of buying the stock (versus buying call options) is quite a bit higher than in a low interest rate environment. It is primarily for this reason that the option pricing model includes an interest rate component. As interest rates rise, buying calls (as opposed to buying stock) becomes a little more attractive, and that drives the price of call options a little higher.

Put option example

If you sell short 200 shares of XYZ at $100 per share, the proceeds of $20,000 will remain in your account and you will likely have an additional margin deposit requirement of $10,000. The $10,000 used to secure the required margin deposit will typically earn money market interest at or near the rate of a Treasury bill. Using a simple interest calculation, if the Treasury interest rate is 0.15%, it will earn about $7.48 (.0015 x 10,000 x [182/365]). However, at a Treasury interest rate of 1.00%, it would earn about $49.86 (.01 x 10,000 x [182/365])—again, more than six times as much.

Instead of short-selling 200 shares of XYZ, you could purchase four at-the-money put options expiring in six months at a price of $4.50 per contract plus commissions. Since at-the-money put options typically have a Delta close to -0.50, initially the profit and loss characteristics of these four put options will be very similar to 200 short shares of XYZ stock.

Since the cost of the options trade is $1,802.60 ([$4.50 x 4 contracts x 100] + $2.60 online commissions), it leaves only $8,197.40 on which you can earn interest. If the US Treasury bill interest rate is 0.15%, this will earn about $6.13 (.0015 x 8,197.40 x [182/365]); and if the Treasury rate were 1.00%, it would earn about $40.87 (.01 x 8,197.40 x [182/365]).

In this scenario, you can see how the opportunity cost of buying long put options (versus selling stock short) is greater in a high interest rate environment than in a low interest rate environment. And even though interest rates have less of an impact on puts than on calls, it’s important for the option pricing model to take interest rates into account. As interest rates rise, buying puts (as opposed to selling stock short) becomes a little less attractive, which drives the price of put options lower.

As shown below, you can visualize the effects of Rho by using Theoretical view on the options chain in StreetSmart Edge and setting the underlying stock price equal to a strike price that is at-the-money. Then compare the price of the at-the-money call and the at-the-money put of the same expiration. In the snapshot below, notice that when the underlying price of the example stock, DIS,1 is set to 185, the theoretical value of the 06/18/2021 185 calls is 9.50, while the theoretical value of the 06/18/2021 185 puts is only 9.46. The difference is relatively insignificant in a very low interest rate environment, but it will increase as interest rates rise.

The effects of Rho

When the underlying price of the example stock (DIS) is set to 185, the theoretical value of the 06/18/2021 185 calls is 9.50, while the theoretical value of the 06/18/2021 185 puts is only 9.46.

Source: StreetSmart Edge®

Using this tool, you could estimate that increasing the interest rate (in the green box) by 1.00% (to 1.15%) would increase the value of the calls by about $0.17 and reduce the value of the puts by about $0.19. While you may not consider this a significant change in price, consider that the Fed funds rate in mid-2007 averaged about 5.25%, which would change the prices of the above call and put options to about $10.42 and $8.49, respectively. Of course, an increase of this amount is unlikely during the course of a year, but it could happen (and has before) over a period of three years, which is more than enough time to dramatically affect the price of LEAPs options.

Options strategies

Now that you understand how interest rates affect the price of options, how can you use this information to create a trading strategy that might benefit from rising interest rates?

In recent years, many ETFs and ETNs (collectively known as exchange-traded products, or ETPs) have been introduced that are tied to various segments of the bond market. You can find these products using the ETF screener available at Schwab.com > Research > ETF Screener.

Using the ETF screener, you can search specifically for ETPs that are tied to various bonds or interest rates. Since a wide variety of choices are available (long-term bonds, intermediate-term bonds, short-term bonds, high-yield bonds, emerging markets, etc.), don’t forget the basic rule that the price of a given bond and the interest rate on that bond are inversely correlated.

Even though some ETPs are difficult to sell short, with such a wide variety of products, you can take a long or short position on bonds or interest rates. With this in mind, here are some things to consider:

  • If you are long a bond ETP, you are short the interest rate on the underlying bond(s). Some examples include TLT, JNK, and HYG.
  • If you are short a bond ETP, you are long the interest rate on the underlying bond(s).

Now that you know how interest rates can affect options and you know which products are tied to bonds and interest rates, you can combine the two items to formulate a strategy that might perform well if you think interest rates will increase. While there are many strategies available, some are likely to be more effective than others. If you expect rising interest rates, below are some guidelines regarding more versus less effective choices.  

More effective choices

  • Short sale on a bond ETP
    • If interest rates rise, bonds should drop in price, causing the bond ETP to drop in price.
  • Covered puts (sell/write) on a bond ETP
    • If interest rates rise, bonds should drop in price, causing the bond ETP to drop in price.
    • The short (covered) puts should rise in value as the ETP loses value, but they should rise in value more slowly due to rising interest rates, increasing the overall profit potential.
    • While this strategy will cap the profits if the short ETP moves sharply lower, it will generally result in a larger profit if there is only a modest move lower in the price of the ETP.
  • Bearish (debit) put spread on a bond ETP
    • If interest rates rise, bonds should drop in price, causing the bond ETP to drop in price.
    • If the bond ETP drops in price, the put spread will rise in value.
    • While the puts will rise more slowly due to rising interest rates, both the long and short puts will be affected, eliminating most of the negative impact of rising rates.

Less effective choices

  • Long puts on a bond ETP
    • If interest rates rise, bonds should drop in price, causing the bond ETP to drop in price.
    • If the bond ETP drops in price, the long puts will rise in value, but they should rise in value more slowly due to rising interest rates, reducing the overall profit potential.
  • Bearish (credit) call spread on a bond ETP
    • If interest rates rise, bonds should drop in price, causing the bond ETP to drop in price.
    • If the bond ETP drops in price, the call spread will fall in value, but the calls will fall more slowly due to rising interest rates, reducing the overall profit potential.

As you can see in these examples, when you combine bond ETPs and options, you have the opportunity to magnify (for better or for worse) your results, if you take into account not just the direction in which you expect interest rates to move, but also how that movement might affect the value of options.

The bottom line

  • Not all ETPs trade options, and some have very low liquidity.
  • Use extra caution when trading low-volume ETPs or those with illiquid options.
  • To profit on most option trades, you will usually need to be right about the direction of the underlying ETP, the magnitude it moves in that direction, and how long it takes to make the move.

1All securities and market data shown above are used for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security.

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