by Thomas Doan
In the Snider Investment Method, we sell options for a premium, which is the amount we receive for selling someone the right to purchase our shares at a particular price over a given period of time. This is the final part of the series, with each article explaining a different component that helps determine the premium of a stock option. The last article discussed stock price and how price movements cause premiums to increase or decrease. This final piece will focus on interest rates and its effect on option premiums.
The risk-free interest rate is a number commonly used in financial models. This is theoretically the amount of interest you can earn by investing in U.S. Treasury Bills (T-Bills) risk-free. The following example uses a call option, the opposite effect applies to put options.
When an investor purchases a call option, the capital investment is small because they are only paying the premium rather than purchasing 100 shares in the market. As a result, investors can purchase call options instead of buying stock and invest the difference in T-Bills to earn interest. As interest rates increase, this causes the option premium to increase because the investor is willing to pay more for the call option in order to invest the difference.
One of the Greeks is rho (ρ), which measures the impact of interest rates on option premiums. If an option has a rho of .1111, then for every 1% increase in the risk-free interest rate, the value of the option will increase by 11.11%.
Although interest rates are a small piece, combined with volatility, time, and stock price movement, these four factors fulfill the pieces of the option premium. With a solid understanding of the factors and the role each one plays, you will better understand how changes in the marketplace impact option premiums.
