Finding the Right Risk
Mick could lower the theta of his position by selecting a put with a greater
number of days to expiration. This alternative has its own set of trade-offs:
lower gamma and higher vega than the 44-day put. He could also select an
ITM put or an OTM put. Like Kim’s call alternatives, the OTM put would
have less exposure to time decay, lower vega, lower gamma, and a lower
delta. It would have a lower premium, too. It would require a bigger price
decline than the ATM put and would be more speculative.
The ITM put would also have lower theta, vega, and gamma, but it would
have a higher delta. It would take on more of the functionality of a short
stock position in much the same way that Kim’s ITM call alternative did for
a long stock position. In its very essence, however, an option trade, ITM or
otherwise, is still fundamentally different than a stock trade.
Stock has a 1.00 delta. The delta of a stock never changes, so it has zero
gamma. Stock is not subject to time decay and has no volatility component
to its pricing. Even though ITM options have deltas that approach 1.00 and
other greeks that are relatively low, they have two important differences
from an equity. The first is that the greeks of options are dynamic. The
second is the built-in leverage feature of options.
The relationship of an option’s strike price to the stock price can change
constantly. Options that are ITM now may be OTM tomorrow and vice
versa. Greeks that are not in play at the moment may be later. Even if there
is no time value in the option now because it is so far away-from-the-
money, there is the potential for time premium to become a component of
the option’s price if the stock moves closer to the strike price. Gamma,
theta, and vega always have the potential to come into play.
Since options are leveraged by nature, small moves in the stock can
provide big profits or big losses. Options can also curtail big losses if used
for hedging. Long option positions can reap triple-digit percentage gains
quickly with a favorable move in the underlying. Even though 100 percent
of the premium can be lost just as easily, one option contract will have far
less nominal exposure than a similar position in the stock.