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A reader of this column wanted to know how a trader should decide between setting up a long call and a short put position for a positive view on the underlying. Accordingly, this week, we discuss how to choose between the two setups.
Potential gains
You must apply two steps to determine whether a long call or a short put offers greater potential gains for a given positive view on an underlying. First, you must choose a call and a put for comparative analysis. The call should be a tradable strike immediately above the spot price to allow room for the option to become in-the-money (ITM) and yet not lose liquidity if the index moves up. With the Nifty index at 17651, this could be the 17700 call. Note that if the index were at 17627, you would still choose the 17700 strike as the 50-strikes on the Nifty index are not liquid; liquidity is important to sell the option and take profits. For the put, you should preferably choose the at-the-money (ATM) strike, as it will provide larger gains from time decay than an OTM put. Also, the ATM strike is most sensitive to decline in implied volatility. Note that decline in implied volatility favours short positions and works against long positions. Based on the option delta, the 17700 put will be considered ATM.
Second, you must determine the potential gains for both the call and the put, assuming the underlying will reach your target price at option expiry. The longer an underlying takes to reach your price target, the lower the gains on your long call. This is because the call will lose time value with each passing day. So, if the long call is profitable at expiry, it ought to be more profitable any time before expiry. This is because you will be able to capture time value when you sell the option to take profits. The short put will generate maximum profits at expiry if the option expires out-of-the-money (OTM). Interestingly, if the underlying moves up quickly, the short put can provide similar gains as the long call; the gains can be attributed to decreasing delta and faster time decay.
The upshot: You should prefer short puts if you expect the underlying to move slowly till option expiry. Otherwise, if the potential gains are similar, the choice between a long call and a short put depends on your risk preference, as a short put exposes you to large losses if the underlying declines.
Optional reading
A long call position has the risk that the target may not be reached before expiry despite an upside movement in the underlying; the loss from time decay will be more than the gains from delta accelerated by the gamma. The risk for a short put position is that the underlying could decline; the loss because of increase in delta will be more than the gains from time decay.
The author offers training programmes for individuals for managing their personal investments
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