Mastering Derivatives: Shorting deep OTM options can be risky

Last week, we discussed why buying deep out-of-the-money (OTM) options on the Nifty Index may not be optimal. This week, we discuss whether it is optimal to short deep OTM options on the index.

Time-decay capture

Brokers typically do not allow their customers to take long positions in deep OTM options because of the restriction on the maximum open interest for each underlying for each broker. Many such brokers, however, allow short positions in deep OTM options. The argument is that long positions (especially in OTM options) end in losses more often than short positions do. According to a leading discount broker, about 80 per cent of long open positions carry losses whereas only 20 per cent of short open positions are in losses at the end of a trading day. This statistics provides only one side of the argument.

Shorting options are negatively skewed strategies. You can generate frequent small gains; losses tend to be infrequent but large in magnitude. This goes with the asymmetric payoff of a long option. The maximum loss for a long call is equal to the option premium, but the maximum gains can be much higher within a defined time horizon. For a short call, the maximum gain is equal to the option premium, but the maximum loss can be higher.

So, should you short deep OTM options? The answer depends on your trading discipline. Given the skewed returns distribution, you should close your short position and take losses, if you observe that the underlying is moving against your position.

Points to note

Options closer to expiry lose time-value faster, increasing the probability of gains for the short position

Time decay always works in favour of the short position, and is a function of the time value of an option

For a short call, the maximum gain is equal to the option premium, but the maximum loss can be higher

Options that are closer to expiry lose time-value faster, increasing the probability of gains for the short position. The price of such options is, however, small. For instance, the near-week 18200 call option trades for 1.20 points. On the other hand, the March 18200 call trades at 15 points. But the March call carries more risk as the underlying can move swiftly against the short position during the remaining life of the option. What should you do?

Also read

Mastering Derivatives: Should you trade deep OTM options?

Suppose you decide to short a deep OTM option on the Nifty Index on the Friday preceding the expiry Thursday. You can short the near-month Nifty call instead of the same strike near-week call. Your trading horizon must, however, be the same. For instance, shorting April Nifty call but closing the position by March 31, aligning with the expiry of the near-week call. The advantage is that you can capture somewhat higher time decay because of higher time value of the longer dated option.

Optional reading

Time decay always works in favour of the short position. And time decay factor is a function of the time value of an option. Now, time value of an option consists of time to maturity and implied volatility. The time to maturity for an option always declines whereas implied volatility can increase, decrease, or remain the same. A decrease in implied volatility accelerates time decay. So, if you have a view that implied volatility is likely to reduce and that the underlying is unlikely to move up during your trading horizon, shorting calls may be optimal closer to expiry.

There are two issues associated with shorting deep OTM options. One, taking losses is easier said than done because we suffer from loss aversion. That means, losses hurt us much more than gains can give us happiness for the same magnitude. To avoid this pain, most traders do not initiate stop-losses. And two, you must short several contracts of a deep OTM call to generate decent gains. This is because of the low absolute price of a deep OTM option. For instance, the maximum gain can be only 750 per contract if you short the March 18200 call at 15 points (permitted lot size 50). This could prompt you to short several contracts. Given the negatively-skewed strategy, your position would be exposed to significant risk.

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

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