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.It’s All About Volatility:What are Kim and Mick really trading? Volatility.

The motivation for buying an option as opposed to buying or shorting the stock is volatility. To some degree, these options have exposure to both flavors of volatility—implied volatility and historical volatility (HV). The positions in each of the examples have positive vega. Their values are influenced, in part,by IV. Over time, IV begins to lose its significance if the option is no longer close to being at-the-money.

The main objective of each of these trades is to profit from the volatility of the stock’s price movement, called future stock volatility or future realized volatility. The strategies discussed in this chapter are contingent on volatility being one directional. The bigger the move in the trader’s forecasted direction the better. Volatility in the form of an adverse directional move results in a decline in premium.

The gamma in these long option positions makes volatility in the right direction more beneficial and volatility in the wrong direction less costly.This phenomenon is hardly unique to the long call and the long put.Although some basic strategies, such as the ones studied in this chapter,depend on a particular direction, many don’t. Except for interest rate strategies and perhaps some arbitrage strategies, all option trades are volatility trades in one way or another.

In general, option strategies can be divided into two groups: volatility-buying strategies and volatility-selling strategies. The following is a breakdown of common option strategies into categories of volatility-buying strategies and volatility-selling strategies:Long option strategies appear in the volatility-buying group because they have positive gamma and positive vega.

Short option strategies appear in the volatility-selling group because of negative gamma and vega. There are some strategies that appear in both groups—for example,the butterfly/condor family, which is typically associated with income generation. These particular volatility strategies are commonly instituted as volatility-selling strategies.

However, depending on whether the position is bought or sold and where the stock price is in relation to the strike prices, the position could fall into either group. Some strategies,like the vertical spread family—bull and bear call and put spreads—and risk reversal/collar spreads naturally fall into either category, depending on where the stock is in relation to the strikes. The calendar spread family is unique in that it can have characteristics of each group at the same time.