If liquidity is important for trading options, why do you analysts recommend shorting deep out-of-the-money options (OTM), where liquidity is typically an issue? In this article, we discuss why liquidity is more important for long positions than it is for short positions.

Short vs. Long

When you buy an option, you are betting on the option generating gains from intrinsic value. That is, if you buy an OTM option, you gain from intrinsic value if the option becomes in-the-money (ITM). Alternatively, you can gain from increase in delta if the option continues to remain OTM even if the underlying moves up. Note, however, that your long position will continue to lose time value with each passing day. So, the gain from intrinsic value or increase in delta must be significant to dominate losses from time decay.

Shorting an option is different. Time decay is a natural process. That is, an option will lose value whether the underlying moves up or down. You should be, however, concerned about the underlying moving against your position. If you short a call option, you do not want the underlying to move up. And if you short a put option, you do not want the underlying to decline.

Take Nifty index. Suppose you short the next-week 17500 call for 102 points. If the Nifty Index moves up from its current level of 17315, then the 17500 call will gather more activity. And that means greater liquidity. So, you can close your short option in the event the underlying moves against your position. On the other hand, if the Nifty Index continues to decline, the 17500 call will lose its liquidity as it would become deep OTM. But that does not cause an issue because the option will lose time value as it approaches maturity. So, in the worst-case scenario where the option that you short becomes illiquid, you can continue the position till expiry at which time you would have realized your gains; note that your maximum gain is the premium collected at the time you short the option.

Liquidity is a function of demand for an option. The demand for an option is based on where the strike is located with reference to the underlying price. Typically, closer the strike is to the underlying price, greater the demand, especially if it is out-of-the-money (OTM). It is in this context that you must view shorting deep OTM strikes or going long on ITM strikes.

Whereas liquidity does not pose an issue for short positions, premiums do. The deeper the OTM option you short, the lesser the premium you will receive. For instance, the 17800 call traded at 31 points, nearly half the premium of the 17600 strike. True, the probability of such options ending in-the-money (ITM) is low. You may have to short several contracts to collect sizable premium. Or you must settle for lower gains in return for the low possibility of the strike ending ITM.

Optional reading

You should observe the build-up in open interest on the Nifty weekly options (calls and puts) to infer the market participants’ view on the underlying. Typically, it can be argued that if the 17400 call has the maximum increase in open interest, then the market participants expect the Nifty index to close below 17400. The logic behind this interpretation is that discerning traders typically short (write) call options. And shorting is profitable only if the underlying is below the strike. You can choose one tradable strike above this strike to improve the odds that the option will expire worthless. Traders prefer to short options closer to expiry. This is because time decay accelerates as an option approaches expiry; for the time value must become zero at expiry. The flip side is that the time value will be small with less time remaining till expiry.

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

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