The Option Greeks - Rho

What Is Rho And How Does It Effect Option Prices?

When it comes to trading or investing in options, one must have a solid understanding of the option greeks in order to be successful.

In addition, one must not only have a working knowledge of the greeks but one must also understand how the greeks work together.

Similar to a puzzle, when it comes to options investing if one piece is missing or unaccounted for the trade will likely not be successful.

Although it may be a lesser known greek, rho plays a vital role in options trading.

What Is Rho?

The greek term rho represents the rate of change in an option's value relative to a change in the risk-free interest rate.

Rho simply measures the amount the theoretical value of an option changes based on a 1% change in interest rates.

Although rho is used less than several other option greeks, it is still an important consideration within an options portfolio or position.

Rho is particularly useful when it comes to investing in equities options as margin accounts must take interest rates into account.

When considering rho, one must consider the fact that the cost of holding a position in a stock is built into the price of the option.

What does this mean?

Well let's say for example, that one is considering a position in XYZ stock.

If one is bullish this stock they can either buy the shares or they can purchase a couple call options that will give them similar exposure.

For example, buying 100 shares or buying two at-the-money calls will give about the same exposure delta wise.

Now, one must take into consideration the costs involved.

Typically, buying the outright shares is going to be a significantly larger cash outlay than simply buying the options.

If one wants to buy the stock, they must pay cash for the entire amount, or purchase the shares using margin.

If margin is utilized, interest will be charged on the amount of funds the customer borrows to make the stock purchase.

If a customer uses his own funds, that money is likely being taken from some type of interest bearing account and therefore there is an opportunity cost when it comes to earning interest on those funds.

Whether one is missing the chance to earn interest or one is paying interest in a margin account, that interest must be accounted for.

Long call positions and short put positions have positive rho.

Short call positions and long put positions have negative rho.

Because it is all about owning a position, such as stock, a rise in interest rates increases the value of calls while decreasing the value of puts.

A drop in rates decreases the value of a call while increasing put values.

How Do Investors Use Rho?

Investors will consider this greek typically when looking to be in a particular stock position.

Simply put, rho is a consideration when it comes to calculating opportunity cost.

Rho is not considered as much of a factor in options trading in an environment of stable interest rates.

Rho is also more of a factor to consider for larger positions as there is more capital involved and thus more interest or opportunity cost.