Trading Options in a Rate Increasing Environment

Within the debt-based monetary model, economic outlooks revolve around central banking. After having engaged in the fastest interest rate hiking cycle since the 1980s, the Federal Reserve set the cost of capital, presently standing within the 5.25 - 5.50% range.

The Fed’s go-to remedy for inflation hasn’t gone smoothly though, incurring $548.6 billion worth of asset losses in a record short period. Since then, the banking fragility has turned up a notch, as Jiang et al. reported that US banks are sitting on ~$2 trillion unrealised losses on securities.

For investors, the resulting monetary dynamic is dual. On one hand, short-term bonds have become a highly sought safe haven asset. Compared to long-term bonds, their yields rise with interest rates while remaining resistant to shifting rates. With each new rate, investors seek higher yields as less attractive bonds expire.

On the other hand, equities represent companies and companies suffer when the cost of capital is more expensive. In turn, lower corporate earnings lead to lower stock prices. Yet, there is a tool to mitigate investment risks - option contracts.    

Why Options Shine in Rising Rate Scenarios 

Following the reheated inflation in August, all eyes are now on the Fed dot plot. In a centrally planned economy, it is the Fed committee that decides the course. The Federal Open Market Committee (FOMC) has twelve members, with each one putting their anonymized weight on the monetary scale.

The Fed dot plot gives the market an insight that curtails market volatility. Will the interest rate go up, hold or get cut? The members’ cluster hints at the direction on a longer timeline, greatly impacting investor behavior.

Each dot represents FOMC member’s view on future interest rates. Image courtesy of the Federal Reserve, as of June 14th, 2023. 

Unfortunately, FOMC members may shift their positions on a weekly basis, turned around by incoming economic data. Moreover, only five out of twelve actually have the voting power, so even clustered anonymized dots lose predictive power.

In other words, investors must navigate imposed volatility by covering their existing positions. This is where options trading strategy shines, as either generating income or simply to prevent major losses.

Whether the Fed hikes, holds, or cuts, options give investors…options to mitigate risk. This comes from the lack of obligation to buy or sell the underlying asset, at a strike price before expiry date, while retaining the right to do so.

Such a combo is ideal to face market uncertainty, with the most popular risk management being the covered call strategy. 

Covered Calls: Income Amid Volatility

Let’s consider the options trading strategy revolving around TSLA shares. This strategy assumes stock ownership where one can either gain income from a call option premium, or utilize the call option to sell the shares.

Reminder, put and call options are two sides of the same option contract. On one side, there is a buying option (bullish call), and on the other side there is a selling option (bearish put). The “covered” part comes into play because the seller already owns the underlying asset, making the bet covered.

This would be in contrast with a “naked” call option wherein the seller doesn’t own the underlying asset, therefore forcing the purchase in the open market for delivery to the buyer.

Simply put (no pun intended), covered call trading entails selling buying options, otherwise known as “buy-write” strategy. In fact, this is so popular that it has been automated by the Nasdaq 100 Covered Call & Growth ETF (QYLG). Year-over-year, QYLG’s performance presently stands at 24.36%.

With that in mind, how does the covered call option strategy play out in the real-world manually?

• You own 100 Tesla (TSLA) shares, trading at $200 per share.
• You are concerned that the Fed could hike again in order to more sustainably crush inflation.
• In such a scenario, TSLA shares’ price would likely be suppressed, but it may not happen at all.
• To cover your position, you sell a call option on TSLA with a strike price of $220, expiring in one month. 

In one scenario, if TSLA stock remains under $220 until expiration, the call option simply expires leaving the investor with a $5 per share premium for selling the option. 

In the other scenario, if TSLA stock goes above $220 until expiration, the buyer would exercise that call option and buy all 100 TSLA shares at $220 per share. Combined with the $5 premium and sale proceeds, the seller gets a tidy $22,500 profit.

Therefore, both outcomes are beneficial for the investor. If the Fed doesn’t follow through on another hike, potentially resulting in higher stock price, one generates $22,500 but no longer owns 100 Tesla shares.

If the Fed follows through with a hike, or some other factor suppresses Tesla outlook, the investor gets the $5 premium while retaining 100 TSLA shares. Then, that premium-based profit could be harnessed to buy the proverbial dip down the line.

Of course, it may happen that TSLA goes beyond $220. With shares sold, the investor could no longer participate in the upside trajectory. Additionally, stock selling becomes a taxable event under the capital gains tax regime.

Using Protective Puts as an Insurance Policy

Now that we covered the buy side (calls), where does the selling side (puts) of options come into play? In the covered calls strategy , investors could sell buying options (calls) to generate income, with the potential downside of no longer owning shares if their price goes up.

Flipping this around, investors can buy a selling option - puts. By buying puts, they gain the right to sell the underlying asset, at a strike price until expiration, but without the obligation to do so. 

As with the previous example, investors own the asset.

However, this time, the goal is to not generate income but to limit losses. Case in point:

• Buy a put option for 100 TSLA shares, trading at $200 per share.
• The strike price of the put option would be $190 with one month expiry date.
• The cost of buying the put option (premium) would be $2 per share, so $2 x 100 = $2,000

In one scenario, TSLA drops to $180, at which point you could exercise the bought options and sell the stock at $190 per share. Even though the shares plunged by $20, you would cut your losses in half as you lose only $10 per share.

In another scenario, TSLA actually goes above $190. The bought puts would simply expire, but you would lose $2,000 for the premium. As the other side of the options contract, these protective puts could be used in conjunction with covered calls.

Moreover, if interest rates stay high for longer, as it appears to be the case from the latest FOMC meeting, investors could deploy protective puts on a portion of their portfolio, the one they deem to be more sensitive to shifting rates.

The success of this strategy will vary wildly, as the put option premium depends on the strike price, expiry date, and the volatility of the asset itself.

Managing Risks with Option Strategies 

The risk in options trading is derived from their inherent components.

Is the option sensitive to the price move of the underlying stock price? This is expressed by the stock’s delta (between -1 and 1), as the contract's sensitivity to a $1 change.

For example, the stock’s long calls are bullish so they typically have positive deltas. This would mean that the call option price is expected to increase as the stock price increases. In the opposite direction, short puts tend to have negative deltas.

For simple hedging, investors commonly buy put options with negative deltas to guard against asset’s price decline. Their losses would be cut because they would exercise the option to sell the asset at the strike price, as noted in previous examples. 

From delta, we derive gamma. This is the rate of change of delta per $1 move in the underlying asset.

The range of expiry date is another risk element to consider. It is important to understand that, as options approach expiration, their value decreases. After all, their value is pinned on the ability to exercise them.

The implication of this is that options have time sensitivity - theta. It plays out differently depending on which side of the options contract investors find themselves. Option sellers, for either puts or calls, benefit from positive theta because contracts become cheaper.

Therefore, the option seller could better realize a profit if the stock is either neutral, bearish (short call) or bullish (short put). At the same time, positive theta would be bad for options buyers as their value decreases.

Most importantly, what is the implied volatility of the underlying asset? This is the market’s expectation on its price moves in the future, expressed as percentages.. Will it move significantly (high implied volatility) or not (low implied volatility). 

As a forward-looking gauge it takes into account the stock's current price, its option’s strike price, expiry date, and the risk free interest rate.

Of course, if the implied volatility is high, the option premium will go up as well because the contract would then be perceived as more valuable. But if premiums go up, then certain option strategies such as protective puts would also become costlier. 

And just as delta measures sensitivity of an option’s price to a change in the price of the underlying stock,  the stock’s vega measures its sensitivity to implied volatility. For every 1% change in implied volatility the contract’s vega of 0.50 would move by $0.50.

Lastly, implied volatility takes into account “risk-free” interest rate. Considering that short-term government bonds are perceived as a safe haven asset, this is then used as a benchmark for comparing the yields on other investments. The risk-free interest rate serves as a hypothetical rate of return in comparison, with rho measuring the sensitivity to changes in interest rates.

For instance, an option with 0.10 rho will have its price increased by $0.10 per every 1% in the risk-free rate. Vice-versa, if there is a 1% decrease.

In practice, if it happens that the option buyer has a high rho, but the risk-free rate increases, the contract’s value will decrease, generating a loss. One should also consider that higher rhos are more common with longer expiry date options because a wider timeline generates wider space for risk-free rate to shift.

Conclusion

At a glance, options contracts seem simple. The ability to exercise a buy/sell right under certain conditions goes hand-in-hand with hedging and speculation. However, once we understand all the risk factors that go into them, complexity branches out exponentially. So much so that one needs many tools under their investing belt, from trading alerts to an advanced understanding of technical analysis when it comes to stock price movement.

This is the difference between hedging and high-level speculation. On the lower risk of this spectrum, covered call strategy is a simple tool to limit the downside risk while simultaneously participating in some upside potential. This makes it a solid starting point to generate income while also getting accustomed with options trading. 

Likewise, protective puts are the go-to low-risk hedging strategy to limit downside risk in a shifting macro-environment. They may incur higher premium costs, but cutting losses in half can make up for it.