This week, we go to the basics of short and long option positions in response to a reader query. The following discussion is relevant for traders who have just begun their journey in the derivatives market.
Right vs obligation
Buying a call option gives you the right (but not an obligation) to buy the underlying. Suppose you buy the November 2340 strike call on Reliance Industries. This gives you the right to buy 250 shares of Reliance at ₹2,340 per share on November 30, the expiry of the contract. To purchase this right, you must pay today ₹38 per option for a total of ₹9,500 per contract (38 times 250). Note that this is an additional cost if you were to exercise the option at expiry and purchase the shares. Like most traders, you can close your long position before expiry and take profits instead of buying the shares.
What if you were to exercise the option? Your counterparty is obligated to deliver 250 shares at the pre-determined price (₹2,340). Note that your counterparty has a short call position. That means your counterparty has an obligation to sell, the opposite of your position (the right to buy). This is the important point. Some believe that the counterparty to a long call is a put position as it is related to selling the underlying. That is not the case.
Just as with calls, there are long and short put positions. A long position in a put option gives you the right (not an obligation) to sell the underlying. Suppose you buy the 2340 put at ₹47 for a total cost of ₹11,750 per contract. You can exercise your right at expiry and sell 250 shares of Reliance at ₹2,340 per share. Your counterparty, being short a put, will be obligated to buy the shares from you.
The above discussion shows that a long call is a right to buy, whereas a short put is an obligation to buy. Similarly, a long put is a right to sell, whereas a short call is an obligation to sell. Appreciating this distinction is important because of the difference in profit potential for long and short positions. A long call has a greater profit potential than a short put because the maximum profit on the latter is just the premium collected at the time of initiating the position.
The understanding of long and short positions enables you to determine the optimal setup based on your view on the underlying. Other factors remaining the same, you must consider either a long call or a short put if you are betting that an underlying will go up. Similarly, you must consider either a long put or a short call if you are betting that the underlying will decline in the near term. You can find previous discussions in this column relating to how to choose between a long and a short option position.
The author offers training programmes for individuals to manage their personal investments