How a Fed Rate Hike Can Affect Option Prices

The price of every listed option is the result of many factors, one of which is interest rates. As a result, it is important for option investors to be aware of Federal Reserve policy decisions.

While rates may not be as influential on option prices as other factors, their impact is nonetheless a component of major pricing models. When rates change, the effect on option premium is represented by one of the option Greeks, called Rho. Specifically, Rho measures the impact of a 1% change in interest rates on an option price. If the Federal Open Market Committee (FOMC), the Fed's policy-setting group, alters its target federal funds rate, that would subsequently affect option premium, in theory, by the amount of Rho.

The extent will vary from option to option, but the expected directional outcome for call options and put options, after a rate change, can be summarized as:

Suppose an investor owns a call and the FOMC raises rates by 25 basis points, or one-quarter of 1%. In this situation, the call price likely would climb, assuming all other pricing factors remain constant. But why? Stocks may respond to a rate increase by declining, so it might seem logical that a long call would do the same, since owning a stock or a call have the same directional bias, that is to benefit from share price increases.

The difference can be explained by comparing the cost associated with each choice. If an investor has $10,000 in cash, and XYZ stock is trading at $100, it would require the entire cash amount to acquire 100 shares. Meanwhile, purchasing one call option on XYZ, which controls 100 shares, would require less capital. If the call were trading at $10, the cost of the position would be $1,000, leaving the investor with $9,000 to place in a separate interest-bearing account.

If that account paid 3% interest a year, it would earn $270 in 12 months on the $9,000. A rate increase to 4% would add $90, as illustrated below. At the same time, the long stock has no cash balance to benefit from higher rates, a scenario that raises the call’s relative value when compared with the stock.

Meanwhile, a long put tends to drop after a rate increase, assuming all other pricing factors remain constant. The reason can be explained by comparing the long put with a short stock position. Though both benefit from share price declines, the short stock can create more interest income as interest rates rise, and thus, its relative value increases when compared directly with the put position. The table below shows a $10,000 account for an investor who is choosing between a long put and shorting stock.

The pricing calculator on the OptionsEducation.org website shows how this would work in more detail. In the first calculation below, the call is at $4.8643, with interest rates at 3%. Rho has a value of 0.0739. If rates increase to 4%, the call option price should rise by 0.0739, assuming other inputs were unchanged.

The bottom calculation reflects the increase - the model predicted the call price would go up by the Rho amount to $4.9382, though in fact the price rose to $4.9392. With Rho, and other Greeks, models may sometimes have a slight variance between the expected and actual price change.

Now turn to puts. The put price in the first calculation is $4.4406 with interest rates at 3%. Rho has a value of -0.0632 (calls have positive Rho and puts have negative Rho). If rates climb to 4%, the put price should decrease by -0.0632, assuming other inputs are unchanged. The bottom calculation reflects the rate change, with a new option price of $4.3774.

Also be aware that rate changes affect longer-term options more than near-term options, particularly when those options have larger amounts of extrinsic value.  The longer the time until an option expires, generally the greater sensitivity to rate changes, because of their elevated values stemming from extrinsic forces.  These options with higher extrinsic values generally have higher absolute Rho values as well.

In summary, investors who own or are considering owning options should understand that changes in interest rates can have an impact on the options prices that are trading in the open marketplace.