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How to manage risk on short calls

Venkatesh Bangaruswamy | Updated on September 11, 2021

Combining short call with long futures or long stock can be relatively less risky

The maximum profit earned by shorting options is the premium, but losses can be large. Small wonder that many are uncomfortable setting up short option positions. In this article, we discuss why combining short call with long futures or long stock can be relatively less risky compared to naked shorts.

Controlling risk

Suppose you short the next-week 17,400 Nifty call for 111 points with the index currently at 17,362. Your view should be that the index is unlikely to move beyond 17,400 when the option expires on Thursday. That means you are setting up the short position to capture profits from time decay or theta. This is the loss in option price due to passage of time with the underlying barely moving from the current level.

Your position is exposed to risk if the underlying moves up sharply immediately after shorting the call. If the index moves up to, say, 17,400 the next day, your short position will carry 11 points of loss, as the 17400 call could be worth 122 points.

But what if you buy the near-month Nifty futures at 17,369 along with the short call? Suppose the index moves to 17,500 three days after you short the 17,400 call. The short call will carry a loss of 54 points. But your long futures would have moved up in line with the 138-point movement in the index (17,362 to 17,500). So, the losses in your short call will be more than offset by the long futures position.

The above illustration is only to show that the short call will not generate losses even if the index moves up sharply. You should, however, set up this position when you expect the underlying to move sideways. The call will shed value quickly through time decay as it approaches expiry; the long futures position is set up to control the risk on the short call.

You should prefer the stock (underlying asset) instead of futures if you were to set up a similar position using equity options. This is because the equity options are driven by the movement in the underlying price; Nifty options are aligned to the Nifty futures contracts, as the underlying index is not tradable.

The short-call long-futures position is exposed to risk when the index declines sharply. This is because futures move in lockstep with the underlying. Suppose the underlying declines to 17,250 three days after you short the 17,400 call, the option will be worth only 44. So, you would have gained 67 points on the short call but lost about 110 points on the long futures. That is the reason the set up works well for a range bound movement in the underlying through expiry (or may be with a slight upward bias).

Optional reading

The strategy is different from bull call spread, where you have a positive outlook with an observable resistance level. In a short-call long-futures strategy, you should choose the ATM call and marry it to the long futures. This is because ATM options have the highest time value and, therefore, offers maximum potential for profiting from time decay.

Note that the short call and long stock can be close to delta neutral when you are setting up this position on equity options. That is, the negative delta of the short call can be neutralised by the positive delta of the long stock.

You should position-size your trade such that for every contract of the ATM call that short, you buy shares equal to one-half of the permitted lot size of the options contract (say 125 shares of Reliance Industries for shorting one contract of the ATM call, permitted lot size of 250). This is because delta of a stock is one and the delta of an ATM option is close to 0.50. You can apply this rule on Nifty futures too.

The author offers training programme for individuals to manage their personal investments

This is a free article from the BusinessLine premium Portfolio segment. For more such content, please subscribe to The Hindu BusinessLine online.)

Published on September 11, 2021

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