Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Go Long Vol in a Rising Interest Rate Environment

This is an observation about the pricing of options.

If we're in a rising interest rate environment, like right now, then the cost of capital is rising.  That is good for volatility premiums of options (the overall option premium).  Here's why:  If I have a higher cost of capital, then it's that much more practical for me to purchase the cheaper options that are further out-of-the-money.  To make the most of this, use a longer duration as it will be affected the most.

 

So, a trade that I like would be to take the 2nd in-the-money call and put options from 2 or 3 months away (to get decent liquidity, the duration needs to be rather close), and to create a straddle for the purpose of creating a synthetic stock.

When the interest rate ticks up, the cost of the underlying asset to a leveraged fund (and most ARE leveraged) goes up, which will mean both options are worth more, even if the underlying asset is worth less.  If the underlying asset is a title company, for instance, the tick up of the interest rate affects their business negatively because fewer people can purchase homes.  This is normal for practically all businesses.  When the price of both options goes up, the straddle makes that much more profit.  Additionally, there is more gamma cushioning the option that's going down in value during underlying asset price movements.