Previously in this column, we mentioned two rules to select option strikes — the implied volatility rule and the liquidity rule. To recap, this rule involves first selecting five strikes — two immediate in-the-money (ITM) options, one at-the-money (ATM) and two immediate out-of-the-money (OTM) options. You should then choose the strike with the lowest implied volatility. Finally, you should check if the strike with the lowest implied volatility also has high liquidity, which is determined by the change in open interest (OI). Over time, we dropped the two ITM strikes, reducing the number of strikes from five to three for easier decision making. This week, we further simplify the rule.
Potential gains
European options can be exercised only at expiry, whereas American options can be exercised anytime during the life of the option. So, the only way you can take profits on European options before expiry is by closing your position. Given the time decay (theta) associated with options, you ought to close your long positions sooner than later. And you need a counterparty to close your position So, liquidity becomes an important factor for closing long option positions.
Suppose you expect an underlying to move up. You must buy a strike that will have liquidity at the time you sell it. That means, the strike that you buy must not be deep ITM at the time you sell it; for, deep ITM options have low liquidity. And yet, you must capture decent gains. To balance this need for liquidity with the desire to capture decent gains, you must buy a strike that is just above the current spot price. This will allow your option to gain some intrinsic value without losing much liquidity. For instance, buying the 22600 call when the Nifty Index is at 22530 with a price target of, say, 22750. The rule then is to buy the immediate OTM strike. This implicitly satisfies the liquidity rule. This strike may not be the least expensive (low implied volatility) among the three strikes, but that is a small price to pay for better liquidity.
Optional reading
For short positions, lower liquidity is not a cause for concern. Liquidity will be low when traders do not demand a particular strike. Typically, traders do not prefer to take long position in a strike which is deep OTM or deep ITM. But deep OTM is also the strike that has a high probability of expiring worthless — the strike that is gainful for short positions if held till expiry. So, is there a simple rule to choose a short strike? If you are combining a short call with a long call, as in a bull call spread, the short strike is typically above an identifiable resistance level. If you setup a naked short position, it is typical, though risky, to short an ATM strike as it will offer maximum gains from delta and vega if the underlying moves in the desired direction.
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