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Last week, we discussed when to setup a short call or a short put position. A short call is an obligation to sell, whereas a short put is an obligation to buy the underlying asset. It is not uncommon for traders to short a call against an existing long position in an underlying. Called a covered call, we have discussed this strategy previously in this column. A covered call protects the short call from losses while attempting to earn the option premium as gains. This week, we look at how to pair a short put as a parallel to a covered call.
Paired puts
You must expect an underlying to sideways or have an upward bias to setup a short put position. But there is always a possibility that the underlying can move down; the put could then become in-the-money (ITM). You have two choices to manage your position. If the underlying breaks the support level, you could close your short put position to cut your losses. If the underlying still trades above the support level, you could decide to wait till expiry. The benefit is that the put will lose value because of time decay as it approaches expiry. So, even if the put is ITM, you could still benefit if gains from time decay is greater than the loss from intrinsic value. But if the put expires ITM, it will be exercised against you. That means you will be obligated to buy the underlying. So, you must have enough money in your trading account to buy the permitted lot size of the underlying.
As a parallel to a covered call, you could create a cash-secured short put position. This position is about having enough money in your trading account in the event you are obligated to buy the underlying at expiry.
Whether the trade will be gainful depends on the premium you receive at the time you short the put. It is better to short an option that has at least 10-15 days to expiry for equity options. For Nifty Index options, it is preferable to short the next-week option on a Friday. The idea is to balance the speed of time decay and greater time value. Note that longer the life of the option, larger the time value. But that also exposes you to the risk of adverse movement in the underlying.
Optional reading
A cash-secured short put is not a mirror position to a covered call. If you start with put-call parity and rearrange the variables, a long bond and a short put (cash-secured short put) is equal to a long underlying and a short call (covered call). But put-call parity requires that the put and the call be of the same strike. The short call in a covered call is an out-of-the-money (OTM) strike. So, the same strike put will be ITM, whereas a cash-secured short put discussed above uses an OTM strike.
The author offers training programmes for individuals to manage their personal investments
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