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November 28, 2016 - Option Trading in an Rising Interest Rate Environment
Want to Fight Rising Interest Rates? Use Conversion Reversals By The Street
Interest rates have a general and specific effect on options pricing. That fact is especially so for the professionals who trade and thus position options in size and volume.
Interest rates have finally begun to get active and rising. Thus you should know the subtle effects that fact will have on the price of puts and calls that you might or will trade.
The general effect that interest rates have on options prices comes into play when those rates are changing the bullish or bearish sentiment of the stock market's valuation. I think of that dynamic as a bell-shaped curve, as I have seen the stock market rise and fall because of a rise or decline in interest rates. Of course, most times, sort of akin to volatility and stock price reaction, the higher interest rates go the more ominous that fact is for stock prices.
Rising interest rates will be a sign that the economy has left the fear stage as demand for capital only occurs when economic optimism is rising, if not taking control of things economic. And of course stock prices rise in anticipation of economic growth.
Rising interest rates create opportunity for the options professional who trades and positions is size in order to make a profit. That profit can be made by executing and thus positioning what is known as the conversion reversal. Make note that I define size as being in the thousands of shares or more.
A conversion reversal is an options combination of long calls, short stock and short puts, where the puts and calls are of the same expiry and the same strike price. This is your basic, almost risk-free, options combination. This is also the combination tactic that generates interest profits like it was a printing press!
One third of the reversal is shorted stock. Shorted stock becomes a credit balance. A shorted stock account's credit balance creates interest like any other credit balance you might have at a bank. Credit balances of trading firms thus receive that interest on a daily basis. The higher the interest rate the more they interest income generated by credit balances, and the more interest income these firms generate. The more they make, the more they want to do conversions reversals, as greed has a funny habit of using perpetual motion.
Now, the net effect of stock being sold short is that this process adds supply to the stock market. That in turn has the effect of creating pressure on stock prices. However, note that call options must be purchased to create the reversal. That creates buying pressure for calls. Puts must be sold to create reversals. That creates selling pressure on puts. All this buying and selling pressure is occurring in a stock market environment in which interest rates are rising.
The net effect that comes into play in tandem with rising interest rates is the fact that this interest rate condition creates upward pressure on the price of call options and downward price pressure on puts. This odd dynamic will be in play regardless of whether or not the cause of rising interest rates is being deemed by the stock market as bullish or bearish.
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Profiting from Trading Stock Options
What Are Stock Options?
Options are financial instruments that give the right, but not the obligation, to engage in a future transaction on some type of underlying security. Buying a call option provides the right to buy a specified amount of a security at a set strike price at some time on or before expiration, and vice versa buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the options writer who sold, or wrote the option must fulfill the terms of the contract.
Options Trading Software Valuation Models
Theoretically the value of an option can be determined by a variety of techniques, software, systems, including sophisticated option valuation software models. These software models can forecast and predict how the value of the option will change with changing market conditions. The risks associated with trading and owning options can now be better understood and managed with higher degrees of precision with these options software models.
Different Types of Stock Options
Exchange-traded options are an important type of options which have standardized contract features and trade on public exchanges, allowing trading among independent parties. Over-the-counter options are traded between private parties, most times well-capitalized institutions, which have negotiated separate trading and clearing arrangements with one another. Another important type of option, particularly in the U.S.A., are employee stock options, that are awarded by a company to their employees as additional incentive compensation.
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