Rho is an option Greek that refers to the rate of change which affects the price of a derivative in respect to interest rate changes. As a Greek measure, it is also used to determine the sensitivity of an option.
As a result, money managers, traders and investors are able to re-balance their investment portfolios finally achieving a risk level that is close to the parameter.
Think of option Greeks as tools or gauges that option traders use to manage their positions just like a pilot uses all those instruments in the cockpit to fly a plane.
Majority of traders and investors consider Rho to be of least importance. Well, this may be attributed to its use in determining interest rate change. Interest rate change is considered insignificant when it comes to the calculation of an option’s price.
Basically, its effect on the price is negligible. Despite this, it remains an important Greek measure.
It is important to note that Rho can either have a positive or negative value. Options with positive Rho value have the chance of experiencing an increase in price. This happens as a result of the increase in interest rates.
The price of the option will subsequently decrease when interest rates decline. Of course in this situation, it is assumed that all factors will remain the same.
Here is a real world example of the situation above. An option price with a Rho value of 0.1 has the ability of increasing by $0.01 on every percentage point as the interest rate experiences an uptrend. Subsequently, it can decrease by $0.01 for every percentage point in case interest rates decline.
This affects long term equity anticipation securities only as they have expiration dates pegged at two years. As a result, they have larger Rho values than short term options.
Does Volatility Affect Rho?
What you ought to know is that volatility has an indirect effect on Rho. Despite this, it still affects the value change of an option which results in the increase or decrease of Rho.
By now you already know that changes in delta affects an option in either out of the money or at the money situations. This means when volatility increases, delta will move closer to 50 and in this case, at the money.
In case of out-of-the-money option, the value will increase when volatility itself increases. This means the value of delta will remain the same and so, Rho will not experience an increase.
At the money option, the value will remain the same when volatility increases which also means delta and Rho values will remain the same.
Rho is considered as one of the least popular Greek measures but it’s vital especially to options traders. This is because it plays a fundamental role in option pricing. It measures changes in interest rates.
The good news is that it does not affect short term options but long term options only since they have more time to expiration.