“INTERESTING” STRATEGY
- Details
- Parent Category: Q & A
- Category: Explore Your Options
- Written by Tom Gentile
With interest rates at historic lows and hard-pressed to drop further, what type of option strategy could take advantage of an increase in rates?
Call options, which have positive rho or interest rate risk, are one good way to capture an anticipated increase in rates. A long call acts as a lower-cost means (dollar basis per contract) to holding an equivalent amount of shares. As borrowing costs — that is, interest rates — rise and the cost to hold the larger capital-intensive stock position increases, a long call strategy becomes more attractive.
Because of this relationship, the call price, all else being equal, will increase to reflect its increased worth as an equivalent strategy for holding long stock. In order to take advantage of rho risk in this capacity, a trader needs to position properly. To do this effectively, the time necessary to capture a lift in rates means going out to longer-dated options, quite possibly a Leaps contract. This is due to a call’s rho factor growing larger per point shift in interest rates as one goes out in time.
When it comes to the actual positioning, traders wanting positive rho risk will look to hedge the call with short stock. This has the effect of neutralizing the call’s delta or directional risk while maintaining the required rho risk component.
One potentially large and maybe unintended risk that the trader maintains with this position is long vega risk and negative exposure to lower implied volatility. More important, as an option’s vega component will invariably be larger than its rho factor, capturing rho risk remains secondary to being confident in maintaining a long vega position.
One alternative option, if you’ll pardon the pun, are interest rate–related products that have listed options. One popular vehicle that falls under this category is the iShares Barclays 20-Year Treasury Bond Fund (Tlt).
The Tlt seeks to track the price and yield performance of the Barclays Capital US 20+ Year Treasury Bond Index by investing at least 90% of its assets in the bonds of the underlying and up to 5% of its assets in repos, cash, and cash equivalents.
As the Tlt’s underlying drops in price as rates increase, a trader wishing to position for an increase in rates would look at purchasing a put contract as the purest play. Other positions such as verticals or calendars may deserve consideration if one also has a view on vega risk.
Contributing analysis by senior Optionetics strategist Chris Tyler
