Mastering Derivatives: Long options optimal for day trades

Last week, we discussed why option spreads are not optimal for day trading. This week, we discuss how short option positions setup for day trading compare with short positions created for position trades. We also show why long positions are preferred instead of short positions for a given intra-day view on an underlying.

Delta gains

Short option positions benefit from time decay- loss in option price because of passage of time. The maximum gain from a short position is the option premium, realized at expiry; for time value of an option is zero at option expiry. But you cannot benefit from time decay when you set up short position for day trading; an option loses value with each passing day, not intra-day. So, how can short option positions generate gains?

The answer lies in another option Greek- delta. This refers to the change in the option price for a one-point change in the underlying. Long call positions have positive delta. That means a call option will move in line with the underlying. So, if a call option’s delta is 0.52, the option price should approximately increase by 0.52 for a one-point increase in the underlying. Likewise, the call option price should approximately decline by 0.52 point for a one-point decrease in the underlying. The opposite is true for puts, as they move inversely with the underlying.

The above argument leads to a simple strategy: You should short calls when you expect the underlying to decline and short puts when you expect the underlying to move up. Suppose you short the next-week 17700 call option on the Nifty Index for 185 points. If the index declines 75 points during the day after you short the option, the call option could decline to 150 points for a gain of 35 points. Assuming the implied volatility of the option does not change, this 35-point gain comes from a decline in call delta from 0.50 when you bought the option to 0.44 after the underlying fell 75 points. Suppose instead, you short the next-week 17700 put on the Nifty Index for 172 points. If the index moves up 75 points during the day after you short the option, the put could decline to 137 for a gain of 35 points.

What if you set up a long call position to bet on the underlying moving up? Then, the 17700 long call could gain 40 points against a gain of 35 points on the short put for a 75-point increase in the index. The argument is no different when you compare long puts with short calls. This suggests that taking long positions in calls are better than setting up short position in puts if your intra-day view on the underlying is positive. Likewise, setting up long puts instead of short calls is preferable for negative view on the underlying.

Also read

Mastering Derivatives: Should you set up spreads for day trading?

Optional reading

Call delta rises at an increasing rate when the underlying rises and decreases at a decreasing rate when the underlying falls. Why?

Just as time decay favours a short position, gamma favours a long position. Note that delta changes as the underlying price changes. This change in delta is captured by the option gamma. For instance, if a call gamma is 0.002 and its delta is 0.50, the delta is likely to increase to 0.502 if the underlying moves up one point but decrease to 0.498 when the underlying declines one point.

Gamma is positive for both long calls and long puts. So, gamma adds to the delta when the underlying moves up and deducts from delta when the underlying moves down. The argument is the same for puts. Because gamma works against the short position, gains from short options are lower than gains from long options. The situation is different for positional trades, as time decay adds to the gains on short positions.

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