Rho is one of the 5 options Greeks that can help us gauge the sensitivity level of an option relative to changes in the risk-free rate of interest. It’s not a very commonly used options metric by most retail investors, however, it can be quite useful for portfolio managers who have exposure to products that hold a strong correlation to interest rate changes.
- Rho is used as a gauge to measure the sensitivity level of an option to changes in the risk-free rate of interest
- It represents the amount of money an option will lose or gain for a 1% change in the risk-free rate of interest
- Rho is positive for long call options and negative for long put options
What is Rho in Options?
Rho measures the sensitivity level of options relative to changes in the risk-free rate of interest. The risk-free rate of interest is the interest rate paid on US T-bills. It represents the amount of money an option will lose or gain for a 1% change in the risk-free rate of interest. It can also be used to measure the overall sensitivity of a portfolio that is full of different options positions.
If an option or an options portfolio has a Rho of 1, for every 1% increase in interest rates the value or premium of the option will increase 1%. Options with the highest sensitivity to changes in interest rates are those that are at the money and with the longest time to expiration.
Rho is just one of the five “Greeks” that measures the sensitivity of options relative to changes in the underlying and other factors like the risk-free interest rate. It’s an important measure because it allows traders to isolate the risk down to a single change in economic policy and how it impacts certain securities. It’s especially useful if you trade options that are sensitive to changes in interest rates.
How is Rho Used In Options Trading?
Using Rho in options trading may not make much sense for most retail traders and investors. There isn’t much that traders can do with the metric unless they are solely trading instruments that react strongly to changes in interest rates.
Interest rates can have an impact on the value of options. If the derivatives you trade have a strong correlation to changes in interest rates it makes sense to pay attention to Rho. If you trade LEAP options Rho may carry a bit more weight to your strategy. This is because interest rate changes impact longer-term options contracts more than short-term options expiration.
If stock prices are high and you trade options over a year out until expiration, they will have a higher sensitivity to changes in interest rates. This will lead to higher Rho values.
Positive and Negative Rho
Positive Rho ( +1)
The value of Rho is positive for long call options and positive for short put options. It increases as the price of the stock increases in value. This is because an increase in interest rates will increase long call options premiums. It will also increase short put option premiums.
Negative Rho ( -1 )
The value of Rho is negative for long puts and negative for short call options. The value decreases and approaches 0 as the price of the stock increases.
How to Decrease Risk With Rho?
Paying attention to interest rate changes in conjunction with Rho can help you manage risk in derivatives that have exposure and sensitivity to interest rates. If you know that certain securities perform well under low-interest-rate environments it may be worth increasing your position sizing.
If there are certain securities that perform worse off in high-interest rate environments, reducing your positions can help you offset long-term directional risk.
Derivatives with High Sensitivity to Interest Rate Changes
As previously stated, LEAP options are most sensitive to changes in interest rates. Paying attention to Rho during the life cycle of a LEAP option can provide insight into the sensitivity skew. In addition to his interest rate futures and options, products can carry high levels of options sensitivity. Some of these include:
- 2 year T-Note Futures – ZTU2
- 5 year T-Note Futures – ZFU2
- 10 year T-Note Futures – ZNU2
- 30 Day Federal Funds Rate – ZQZ2
These products will have higher levels of sensitivity to changes in interest rates. Rho can be useful when looking at longer-term options contracts in these products.