If a call and a put are equidistant from an underlying’s price, will both strikes have the same price? This week, we discuss why the price of an equidistant out-of-the-money (OTM) call and put may be different, and how this argument can be incorporated into your trading strategy.

Asset price distribution

An asset can continually rise but cannot go below zero. Therefore, a call has unlimited upside, and a put has limited upside. This is because call option’s value increases when an underlying increases and put option’s value increases when the underlying decreases. So, all other factors remaining the same, a call option will have a higher value than a put option for strikes equidistant from an underlying’s price. For a stock trading at 500, the 520 call will have a higher value than a 480 put of the same expiry.

That said, the unlimited upside potential for calls is difficult to defend for short-dated options. In the short term, what matters is whether an underlying is likely to move up or decline before option expiry. When an underlying is trending up (down), demand for calls (puts) is likely to be greater. And when the underlying is trending down (up), demand for calls (puts) is likely to fall.

Now, implied volatility is derived from the option price. Traders use this volatility because Black Scholes Merton (BSM) model assumes volatility to be a constant which does not hold in the real-world markets. Note that implied volatility is a function of demand for a strike. That is, if other variables determining an option price were to remain the same, a change in option price because of higher demand will increase the option’s implied volatility. For instance, the next-week 18600 Nifty call trades at an implied volatility of 12.42 per cent, whereas the 18500 put trades at 11.99 per cent with the Nifty Index trending up and currently at 18552. A change in the trend will have an opposite effect.

Making gains
A short call or a short put position captures gains from decline in the option’s delta and implied volatility

The upshot? If you expect a small price reversal in an underlying after a continual uptrend, shorting an out-of-the-money (OTM) call may be better than buying an OTM put which may be equidistant from the underlying price. Likewise, when you expect a small reversal in the underlying after a continual downtrend, shorting an OTM put may be better than taking a long position in an equidistant OTM call.

Optional reading

A short call or a short put position captures gains from decline in the option’s delta and implied volatility. For instance, the 18600 next-week Nifty call will most likely generate 63-point gain if the index declines to 18500 from 18552, four days after you short the option. The 18500 Nifty put short will most likely generate 45-point gain if the index were to increase to 18600 during the same period. If you buy the 18600 Nifty call instead, to bet on the small upside potential, you will most likely lose 16 points.

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

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