Last week, we saw a massive broader market sell-off that, in part, appeared to be a reaction to stronger economic activity. This included 4% GDP growth in the second quarter and strong labor market data. These reports added to concerns that the Federal Reserve will allow interest rates to rise sooner than expected.

As economic activity picks up, the danger of inflation also rises -- and the Fed's primary weapon against inflation is higher interest rates. After a period of near-zero rates, an uptick in Treasury yields could cause a significant shock to the system and trigger a flight out of equities and into higher-yielding fixed-income products.

Of course, there is a tremendous amount of uncertainty in the market right now as the Fed's future path is in question and the economic recovery is anything but certain. Several Fed officials have indicated that any rate hike will probably not occur until late 2015, but it's always a good idea to be prepared.

The big question for us is how the new environment will affect our ability to generate income selling puts. And the answer may be a lot more exciting than you anticipate.

Key Factors for Options Pricing

Our income strategy is centered around selling put options on stocks that we would generally like to own. Buy selling a put contract, we are accepting the obligation to buy a stock at a particular price, known as the strike price (usually below the current market price for our purposes), within a defined time period. We are compensated for taking on this obligation, and the premium we receive from selling the option contract is what generates income in our account.

It stands to reason that the higher the option premiums, the more income we can expect to generate in our account. So what are the catalysts that drive options prices higher, and what kind of pricing can we expect over the next year or so?

Options are very statistical vehicles, meaning they derive their value from key statistical qualities of the underlying stocks that they represent. Specifically, options pricing is heavily affected by two key issues:

1. Volatility, specifically the expected volatility of the underlying stock or security.

2. Interest Rates, specifically the risk-free rate, which is usually equated with the yield on Treasury bills.

There are a few other considerations taken into the pricing models. But these two issues account for the majority of option pricing dynamics.

Don't worry, we're not going to get into a deep statistical discussion here. But I do want to explain why higher interest rates will actually kick off a healthy environment for selling put contracts.

The Volatility Factor

Uncertainty in the broader market applies directly to option prices, which tend to rise when risk (or uncertainty) is elevated. Higher option prices, of course, add to the profitability of our put selling strategy.

As we draw closer to a rate hike, traders will move capital into areas that are expected to do well in a rising interest rate environment and out of areas that are higher risk.

Considering the fact that interest rates have been very low for a long period of time, this capital rotation will represent a major shift. Traders have been conditioned to expect low interest rates for years, so they have had plenty of time to optimize their portfolios for a low-yield environment.

As a huge amount of capital shifts back toward a more "normal" rate and economic environment, volatility will naturally increase.

So our strategy of selling puts on stocks that we want to own becomes even more lucrative because we are receiving more compensation for the puts we are selling.

Equities are likely to be falling as rates increase, which means that we will be able to sell puts with lower strike prices -- giving us even more attractive buy points if we are actually obligated to purchase shares of stock.

The Interest Rate Factor

Higher interest rates also add to the premium level of option contracts. The rationale is a bit more statistically involved, but the basic idea is that with higher interest rates, traders have more opportunity costs for income strategies. This is because they can own Treasuries that pay a higher interest rate, so traders should demand even more income for strategies that require taking on more risk.

So simply as a function of higher interest rates, we can expect option prices to trade higher, giving us more income for our put selling strategy.

Despite the uncertainty surrounding the Fed's actions right now, I am very excited about our put selling strategy and continuing to generate a healthy rate of return by collecting premiums -- and potentially buying quality stocks at very attractive prices.

She recently closed her 63rd straight winning trade. If you're interested in guided put selling recommendations, my colleague Amber Hestla has a stellar track record. Check out her books and get prepared for a rising interest rate environment now by clicking here.

]]>

Related Articles
  1. Taxes

    What IRS Form 8949 Is For

    Selling a painting or that lake property? Disposing of your fossil fuel stocks? You need to know about this IRS form.
  2. Investing

    Five Things to Consider Now for Your 401(k)

    If you can’t stand still, when it comes to checking your 401 (k) balance, focus on these 5 steps to help channel your worries in a more productive manner.
  3. Investing

    What’s Holding Back the U.S. Consumer

    Even as job growth has surged and gasoline prices have plunged, U.S. consumers are proving slow to respond and repair their overextended balance sheets.
  4. Economics

    The Problem With Today’s Headline Economic Data

    Headwinds have kept the U.S. growth more moderate than in the past–including leverage levels and an aging population—and the latest GDP revisions prove it.
  5. Forex Education

    China's Devaluation of the Yuan

    Just over one week ago the People’s Bank of China (PBOC) surprised markets with three consecutive devaluations of the yuan, knocking over 3% off its value.
  6. Fundamental Analysis

    Calculating Return on Net Assets

    Return on net assets measures a company’s financial performance.
  7. Investing Basics

    Explaining Rehypothecation

    Rehypothecation occurs when an asset used as collateral for one party is reused in another transaction.
  8. Investing Basics

    What's a Price-Taker?

    Price-taker is an economic term describing a market participant who has no effect on overall market activity.
  9. Economics

    Explaining the Participation Rate

    The participation rate is the percentage of civilians who are either employed or unemployed and looking for a job.
  10. Economics

    Understanding Organic Growth

    Organic growth is the increase in a company’s revenue and value due to internal operations.
RELATED TERMS
  1. Yield To Maturity (YTM)

    The total return anticipated on a bond if the bond is held until ...
  2. Gross Profit

    A company's total revenue (equivalent to total sales) minus the ...
  3. Interest Coverage Ratio

    A debt ratio and profitability ratio used to determine how easily ...
  4. Monetary Policy

    The actions of a central bank, currency board or other regulatory ...
  5. Receivables Turnover Ratio

    An accounting measure used to quantify a firm's effectiveness ...
  6. Remittance

    The term most commonly refers to money being sent via mail or ...
RELATED FAQS
  1. Are spousal Social Security benefits taxable?

    Your spousal Social Security benefits may be taxable, depending on your total household income for the year. About one-third ... Read Full Answer >>
  2. What are the best ways to sell an annuity?

    The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
  3. How are non-qualified variable annuities taxed?

    Non-qualified variable annuities are tax-deferred investment vehicles with a unique tax structure. After-tax money is deposited ... Read Full Answer >>
  4. Why would someone change their Social Security number?

    In general, the Social Security Administration, or SSA, does not encourage citizens to change their Social Security numbers, ... Read Full Answer >>
  5. Are spousal Social Security benefits retroactive?

    Spousal Social Security benefits are retroactive. These benefits are quite complicated, and anyone in this type of situation ... Read Full Answer >>
  6. Is Argentina a developed country?

    Argentina is not a developed country. It has one of the strongest economies in South America or Central America and ranks ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!