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Profit versus liquidity in options trading

Venkatesh Bangaruswamy | Updated on September 04, 2021

Capturing target upside potential even as underlying moves up

Option traders should typically close their long calls even if the underlying continues to move up. This is because the strike they hold could turn illiquid when it becomes in-the-money (ITM), especially the farther the strike is from the spot price. In this context, this week, we evaluate whether it is optimal to buy a call one strike above the price target on the underlying. The objective is to allow the position to capture the target upside potential without losing liquidity even as the underlying continues to move up.

Delta vs time decay

A tradable strike is one that is currently liquid and continue to be liquid, especially when you close your position. For the Nifty Index, this refers to strikes ending in 100s and typically one strike on either side of the at-the-money (ATM) strike. In this context, we evaluate the 17000 strike with the underlying at 16885.

Suppose you buy the 17000 call for a price target of 16950 on the underlying. Note that this statement is counter-intuitive. While discussing bull call spread, we noted that if you believe that an underlying faces resistance at a certain level, you should consider shorting one strike above this level and create a bull call spread. And yet, we are considering a long position in a strike that is above the price target. This is because we are trying to evaluate if a tradable OTM strike will enable us to capture the target upside potential in the underlying without losing liquidity.

Suppose you buy the next-week 17000 Nifty call for 72 points. This long call will be profitable only if the underlying moves up quickly, as the option will lose value due to time decay. Note that the position cannot generate intrinsic value because the strike will not be ITM when the index reaches 16950. So, the option must generate profits because of greater possibility of the strike ending ITM, captured by option delta.

The call could be worth 93 points if the underlying moves to 16950 one day after you set up the position. If the index reaches 16950 four days later, the call could be worth only 70 points. True, if the index instead reaches, say, 17100, the call could be worth 155 points. That is, 100-point move beyond the price target could contribute to 85-point increase in the option price. But you are setting up the position for a specified target. So, your profit potential should be measured against this target price, not for price movement above it. The upshot? When the target price on the underlying is below the strike, your position could be profitable only if there is a swift movement in the underlying. Buying an ATM or an OTM strike that can become ITM may be more profitable. You may have to sell these strikes before they turn illiquid, but chances of generating profits are higher.

Optional reading

The delta of the OTM call increases as the underlying moves up. Also, faster the change in the underlying price, greater the change in delta. But farther the OTM strike is from the spot price, lower the delta of the option. Note that lower the delta of the option, lower the sensitivity of the option price to the change in the underlying.

Therefore, if the underlying moves to 16950 a day after the long position is set up, the delta of the 17000 call increases swiftly to 0.46 from 0.35. This increase in delta with only a marginal loss in time value enables the position to generate profits (21 points). If the underlying moves to 16950 four days after the position is set up, the increase in option delta is not enough to counter the time decay over four days. Hence, the option could be worth only 70 points (two-point loss).

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

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Published on September 04, 2021

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