How do we use Rho to Trade Options?
In the middle of the other ‘Greeks’ namely Delta, Gamma, Theta and Vega, the mathematical risk measurement tools that helps option traders to execute stock research and make investment decisions, one Greek that stands discriminated is the Rho.
Other Greeks deal with the sensitivity of the options with respect to changes in the price of the underlying asset and time decay, Rho is a measure of the sensitivity of options to change in interest rates.
Definition of Rho
It can be defined as “the rate at which the price of a derivative changes relative to a change in the risk-free rate of interest. Rho usually measures the sensitivity of an option or the options portfolioto a change in the interest rate “.
Significance of Rho
Other Greeks help in necessary technical analysis for stock trading approximately on a regular basis.
Rho is not a measurement tool that would be requisite to be studied on a regular basis.
Rho will be required only when interest rates are changing too frequently or at the time of an interest rate change.
In most developed economies, it is seen that interest rates are changes only occasionally and not too often, making Rho a comparatively less important measurement tool for option traders.
As more often than not, option buyers borrow money from the market to invest in options, it is significant to understand the comparative effect of change in interest rates in comparison with the change in the price of holding the option as the same will have a direct impact on the cost of the options and look into formative the opportunity cost of holding the options as against the risk-free interest that could be earned on the money invested in options.
What is the relevance of Rho?
The use of Rho would be more pertinent in the case of long-term options than short-term options for the chances of interest rates changing are higher in the long run.
The Rho for long term options will naturally be more sensitive and an option trader must not abandon the likely impact of interest rate changes on the investment as a whole.
Rho may not be the most important risk measurement Greek, it ensures the investor to make informed decisions and not lose out on profit earning opportunities.