How do interest rate movements affect option prices?
Let’s say you have a bullish view on Tata steel. You can choose to either buy a call option or alternatively, buy the stock in the cash market. Remember that buying from the cash market has two challenges:
1) You need to put down a larger amount upfront.
2) If you buy the stock and the stock falls, you will be in a losing position with unlimited downside.
Additionally, you also have a view that interest rates are going to be higher in the future. So, what should you do?
Buy the call or buy the stock?
Let's say you buy the call. Here are the benefits:
1) Option premium will be low compared the outlay in buying the stock in the cash market
2) You can participate in an unlimited upside
3) Your downside is limited even when the stock tanks - the worse that can happen is that the stock moves down and you lose the entire option premium
4) You can now invest the amount you have saved (by not buying the stock) to earn a higher interest rate in the future
Therefore, when interest rates are expected to go higher, call prices rise (call demand increases as more and more people want to buy calls) and put prices fall. The Greek that measures this sensitivity is Rho.
It measures how much an option’s price changes when interest rates change. Call options gain value when interest rates increase, while put options lose value. Rho is usually less important when rates are steady, but it matters more when interest rates start moving around.
Disclaimer:
This information is for educational purposes only. Trading in Futures and Options involves substantial risk and is unsuitable for all investors. Past performance is not indicative of future results. Consult a financial advisor before engaging in such trading activities.
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