Mastering Derivatives: Why institutional investors prefer short positions

Last week, we discussed the relation between open interest (OI) and prices. Responding to the article, a reader wanted to know why institutional investors typically prefer short positions in options. In this article, we look at the characteristics of short options and why discerning investors and large traders typically prefer short positions.

Capturing time decay

According to a leading broker, about 80 per cent of open long positions carry losses by the end of a trading day. If you immediately conclude that shorting options are more gainful than going long, consider this. When options expire in-the-money (ITM), short positions are likely to suffer large losses. Short option positions are negatively-skewed returns strategies. That means traders shorting options are likely to earn frequent small gains, but infrequent large losses. This indicates that shorting options are typically risky.

Note that maximum gains from shorting options come from capturing time decay. That is, with each passing day, options — calls and puts — lose time value, which eventually becomes zero at expiry. In the case of ITM options, gains could also come from loss in intrinsic value.

Now, consider the options market. For every long position that is open, there must be an equivalent short position. But if carrying overnight short positions are risky, which market participant is likely to do so? Institutional investors, for two reasons. One, they have the financial capacity to take losses. And two, they are better placed to take a view on an underlying than retail investors.

That said, institutional investors do not necessarily go naked short (uncovered open short positions), as such positions are exposed to high risk. Rather, these investors could be shorting options against long positions in futures or the underlying.

Also read

Mastering Derivatives: Understanding the relation between OI and prices

Let’s say that an institution has a positive view on an underlying, but believes that the underlying will face resistance at an identifiable price zone. The institution is likely to go long on futures and short an out-of-the-money (OTM) call. If the underlying moves up, the institution will gain from the long futures position. And yet, if the underlying stays below the call strike at expiry, the institution would have also gained from the short call, as the option will expire worthless.

This strategy requires a lot of conviction. You take a long position in futures, expecting the index to move up. And even as the index is moving up, you short OTM calls. This is because calls will trade for a higher price when the underlying is moving up. Note that the higher demand for a strike will push the option price up. Therefore, the implied volatility of these options will be high. Note that implied volatility is a component of time value. If the underlying struggles to move up after the initial rally, time decay will accelerate as both time to expiry and decline in implied volatility will push the option price down.

Retail investors can set up this strategy. But even if an individual has large trading capital, the issue is about regret. When a person suffers consecutive losses, it is possible that he/she would give up on the strategy, as losses can be emotionally stressful. Besides, the risk of large losses typically keeps retail investors away from shorting large quantities.

Strategy snippets

When options expire ITM, shorts would suffer large losses

Traders shorting options could earn frequent small gains

For every long position, have an equivalent short exposure

Optional reading

Institutional investors do not always short options. A class of hedge funds called tail-risk funds bet on extreme events. These are events of low probability and high magnitude. The market crash during 2020 when the world economies imposed lockdown, for instance. These funds, in addition to other strategies, take long positions in long-dated deep OTM index puts. This strategy has a positively-skewed returns distribution. That is, the strategy will generate frequent small losses arising from loss of option premium but infrequent large gains when markets crash. Typically, however, institutional investors prefer to take short option positions to capture time decay.

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

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