It is important to estimate the speed at which the underlying is likely to reach its target
In the past two weeks, we discussed the risk and the returns associated with short call and short put positions. The question is: How do you decide whether to set up a long or a short position? This week, we discuss issues relating to choosing between a long call and a short put.
Long call vs Short put
Suppose you have a view that the underlying is likely to move from 15730 to 15820. Further suppose you have to choose between a long position on the 15700 call or a short position on the 15700 put. Note that even though the 15700 call carries intrinsic value, we will consider that as an at-the-money option (ATM) in line with our rule that an ATM option is the one that is closest to the current spot price (ignoring the 50s strike for the Nifty Index). By the same argument, the 15700 put is also ATM. The next-week expiry 15700 call trades for 152 points and the same expiry 15700 put for 118 points.
Now, suppose the underlying value is 15820 at option expiry. The 15700 call would be worth 120 points, suffering losses despite a 90-point increase in the underlying. On the other hand, the 15700 put would have expired worthless, thereby generating 118-point profit. Even if the underlying trades at 15820 earlier in the expiry week, the short put would have provided higher gains than the long call. Why?
The reason has to do with time decay. Note that time decay lowers gains or increases losses on long positions but contributes to gains on the short positions. The 15700 call has 122 points of time value (option price less intrinsic value). The 90-point gain in the underlying was not enough to counter the erosion in time value because of passage of time.
So, does this mean shorting puts is typically profitable? The answer depends on several factors. One, the estimated upside price movement in underlying. Two, the premium on the short put and the time value of the long call. And three, when do you expect the underlying to reach its target price. The longer the time for the underlying to reach its price target, higher the likelihood that the short put will be more profitable than the long call.
Suppose the underlying moves from 15730 to 15818 (strike plus put premium) the day after you buy the 15700 call. The long call will generate higher profits. The reason is because the increase in intrinsic value and time value capture on the long call is greater than the gains from time decay on the short put. However, if the underlying were to reach 15818 a day later, the short put will be profitable. The pattern is similar if the underlying trades at 15852 (15700 plus call premium).
The above discussion brings to the fore a key issue with options trading- estimating the speed at which the underlying is likely to reach its target. Technical analysis can help you fix a price target. But you may be unable to determine when the target will be reached. You can improve the chances of winning by having a view on implied volatility. The point is that deciding between a long call and a short put may not be easy.
You should be mindful of the following before shorting a put. First, time decay accelerates as the option nears expiry. So, shorting options during expiry week is better, especially if the ATM call and put premiums are similar and you expect the underlying to move sideways or move marginally higher. Second, a short put is an obligation to buy the underlying. You will have to, therefore, maintain margins on your short position. Finally, shorting options exposes you to large infrequent losses, which can wipe out your frequent small gains from such short positions.
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