Derivatives

How to gain from time decay in Nifty, Bank Nifty options

Venkatesh Bangaruswamy | Updated on June 06, 2021

The speed of fall in value of options accelerates near expiry

Last week, we discussed the risk and the returns associated with short put position. This week, we discuss short calls including how to manage such a position on the next-week Nifty and Bank Nifty contracts.

Limited return, higher risk

When you short a call option, your maximum profit is the option premium. You can earn this maximum profit at expiry, if the call option ends out-of-the-money (OTM). This shows that shorting calls is optimal when you expect the underlying to move sideways or decline marginally. This is because profits on the short call position comes from loss in the time value of the option if you buy an OTM or an at-the-money (ATM) option; both OTM and ATM options have only time value and no intrinsic value. Note that if you expect the underlying to decline significantly, your profits could be greater if you buy a put option.

So, after you take a view on the underlying, which strike should you short? You should first select the at-the-money (ATM) option, the immediate in-the-money (ITM) option and the OTM option of near-month expiry. Based on the reverse implied volatility rule, you should short the strike that has the highest implied volatility.

In the case of the Nifty and the Bank Nifty indices, a question may arise as to which expiry contract to short? Should you short the near-week or the next-week expiry? Again, the answer depends on implied volatility. You have to select the three strikes (the immediate ITM, the ATM and the immediate OTM) of the near-week expiry and the same strikes of the next-week expiry. You should short the one that has the highest implied volatility of the six strikes selected. You can use an option calculator available on the internet to determine the implied volatility.

Typically, the near-week contract would have greater implied volatility. This follows from a higher demand for the near-week contracts compared to the next-week contracts. Note that higher the demand for a strike, greater the change in price relative to other strikes and, therefore, greater its implied volatility. For instance, the implied volatility of the near-week 15600 strike is greater than the implied volatility of the next-week 15600 strike. Suppose you short the 15600 strike near-week contract for 63 points. If the underlying declines from 15575 to 15510 a day later, you could close your short position for a 44-point profit.

Optional reading

What if the next-week contract has higher implied volatility? Then, you should carefully manage your short position as you are exposed to high risk. Your counter-party can only exercise the option at expiry because you are shorting European options. So you have the opportunity to close your position any time before expiry. But to do that, the option must be liquid. It is, therefore, important you close the position when you expect liquidity to decline on your short call.

One rule would be to close the position when the short call is more than one tradable strike away from the current ATM strike. A tradable strike on the Nifty would be intervals of 100, as the 50 strikes are not actively traded.

With the underlying at 15575, suppose you short the 15600 call next-week contract for 140 points. If the underlying declines to 15510 the next day, the 15500 strike will be the ATM option. Your 15600 call is one tradable strike away from the ATM option. You could close your position at 101 points for a 39-point profit. This is lower than the 44-point profit on the 15600 strike of the near-week contract for the same price movement in the underlying. This is because time decay (that drives profits for short position) accelerates as the option nears expiry. So, the time decay of the near-week strike is greater than that of the same strike of the next-week contract.

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

Published on June 06, 2021

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