Long OTM Call
Kim can reduce her exposure to theta and vega by buying an OTM call. The
trade-off here is that she also reduces her immediate delta exposure.
Depending on how much Kim believes Disney will rally, this may or may
not be a viable trade-off. Imagine that instead of buying one Disney March
35 call, Kim buys one Disney March 37.50 call, for 0.20.
There are a few observations to be made about this alternative position.
First, the net premium, and therefore overall risk, is much lower, 0.20
instead of 1.10. From an expiration standpoint, the breakeven at expiration
is $37.70 (the strike price plus the call premium). Since Kim plans on
exiting the position after about three weeks, the exact break-even point at
the expiration of the contract is irrelevant. But the concept is the same: the
stock needs to rise significantly. Exhibit 4.6 shows how Kim’s concerns
translate into greeks.
EXHIBIT 4.6 Greeks for Disney 35 and 37.50 calls.
35 Call37.50 Call
Delta 0.57 0.185
Gamma0.1660.119
Theta −0.013−0.007
Vega 0.0480.032
Rho 0.0230.007
This table compares the ATM call with the OTM call. Kim can reduce her
theta to half that of the ATM call position by purchasing an OTM. This is
certainly a favorable difference. Her vega is lower with the 37.50 call, too.
This may or may not be a favorable difference. That depends on Kim’s
opinion of IV.
On the surface, the disparity in delta appears to be a highly unfavorable
trade-off. The delta of the 37.50 call is less than one third of the delta of the
35 call, and the whole motive for entering into this trade is to trade
direction! Although this strategy is very delta oriented, its core is more
focused on gamma and theta.