Mastering Derivatives: Why European options are favourable for shorts

Venkatesh Bangaruswamy | Updated on: Sep 10, 2022

A key reason is that one has more choice of strikes to set up short positions than long positions

European options are more favourable for short positions than for long positions. One reason is because you have more choice of strikes to set up short positions than long positions. This week, we discuss why this is so. We also show why you do not have to adjust your short positions when you are trading European options.

Short vs Long

Academic literature typically argues that it is not optimal to exercise an option. Why? You realise only intrinsic value when you exercise an option, whereas you can capture both intrinsic value and time value when you sell an option. If selling is the preferred choice, then a trader ought to be indifferent between an American and a European option. The issue, however, is that liquidity becomes important when you want to sell an option.

On the NSE where European options are traded, typically at-the-money (ATM) and several out-of-the-money (OTM) strikes are actively traded. Importantly, in-the-money (ITM) strikes are not liquid. Why? ITM strikes already have intrinsic value. So, the absolute premiums for these strikes are high. Traders do not prefer to invest large amounts to buy options.

This leads to an interesting situation. ITM options have lower time value than ATM and OTM options. This is because time value is determined by the demand for an option. Lower the demand, lower the time value. This means the time decay (loss in time value) of ITM options is lower than that of ATM and OTM. But the risk that you may be unable to take profits on your long positions because of lower liquidity makes ITM strikes less desirable. As for deep OTM strikes, the chances of gains are low. Hence, long positions are typically set up using ATM and several OTM options.

What about short positions? When you short an option, your objective is to capture time decay. So, when you expect an underlying to move up (down) after a downtrend (uptrend), you can short an ITM put (call) if you can find a counterparty. As for shorting OTM strikes, the greater the distance an option is from the spot price, the higher the likelihood that it will expire worthless. And this means greater the chance that the short position will generate gains. Note that lower liquidity is not an issue for taking profits on short positions; for lower liquidity typically indicates less gainful opportunity for long positions.

The above argument suggests that the choice of strikes for short positions can extend to ITM and deep OTM strikes. This suggests that European options are more favourable for setting up short positions than long positions. Note that you can exercise deep ITM American calls if you are unable to take profits. Therefore, choice of strikes to setup long positions is more for American options than for European options.

Optional reading

A secondary effect of the above-mentioned liquidity issue is that you cannot trade European options for large price targets; farther the spot price moves from the strike, lower the liquidity of an ITM option. This leads to a concept called tradable strikes (liquid options) for European options. Typically, ATM and two-three immediate 100-strike OTM options are liquid on the Nifty Index.

Lower liquidity
You cannot trade European options for large price targets; farther the spot price moves from the strike, lower the liquidity of an ITM option

Suppose you buy the ATM call to bet on a view that the Nifty Index will increase by 300 points. You may be forced to sell the call when the option carries about 100 points of intrinsic value. If you hold your initial view on the underlying, you should buy the then ATM or immediate OTM option soon after you take profits on your existing position. That is, you must balance gains and liquidity while trading European options, a trade-off that may not be required for American options. Note that this trade-off is required only for long positions, another reason to suggest that European options are biased towards short positions.

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

Published on September 10, 2022
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