Rho, Rho, Interest Rates...

optionsguy posted on 04/29/10 at 10:04 AM

In this back-to-basics series Brian Overby reviews the Greeks, factors to help you gauge the impact of various changes on option contract prices. Today's post continues a discussion on Rho, the interest-rate Greek.

Welcome back to the final post in my series on the Greeks. Last week we introduced rho, the "interest-rate Greek." Technically speaking, rho measures the amount a theoretical option's price will change for a corresponding one-unit (percent) change in the interest rate used to price the option contract. But as you'll learn in today's post, rho also reacts to dividends and other factors in the marketplace. We'll explore some of those in more detail today.

To recap, rho deals with carry costs, the opportunity cost of sinking your capital into one investment instead of another. Calls have a positive rho value, while puts have negative rho. That suggests an increase in interest rates will cause calls to become more expensive and puts to become less expensive.

Rho reacts similarly to vega, the volatility Greek, when it comes to changes in price variables. The two things that create exposure to a change in interest rates/rho are the length of time until expiration, naturally, and the price of the underlying. Longer-term options will usually have larger rho numbers compared to shorter-term. Rho also tends to get larger the more expensive the underlying security is.

Dividends paid by the underlying are also a part of carry costs - that is, a dividend payment offsets the interest cost to carry the position. So the dividend payouts tend to have an opposite effect from the one described above: if the underlying security increases the dividend or decides to start paying one, calls usually become less expensive and puts tend to become more expensive.

If you’re a fan of LEAPS on large blue-chips in particular, rho is something to make note of. LEAPS stand for Long Term Equity AnticiPation Series, basically longer-term options which are particularly impacted by rho. In fact, rho can represent a large portion of a LEAPS option’s price.

Bottom line of this series: know your Greeks, and you can sidestep a lot of common options-trading mistakes - and who doesn't want to do that?

Send me your questions about any of the Greeks, and I'll post any followups here. Otherwise, see you next week!

Brian Overby
TradeKing's Options Guy

[image: Giardini di Mirò, Live @ Rockin'Rho, 17.09.2006 by zabriensky what? on Flickr]

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Even though the Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that these forecasts will be correct.

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Posted by optionsguy on 04/29/10 at 10:04 AM


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