You have a view that an underlying is likely to move up. Should you short an in-the-money (ITM) put or go long on an at-the-money (ATM) call to capture the expected movement in the underlying? This week, we discuss the pros and cons of shorting an ITM option.
Suppose you expect the Nifty Index to increase to 16750 before the expiry of the next week contract. With the index currently at 16323, suppose you narrow your choice to next-week 16500 ITM put (358 points) or the 16400 call (365 points). If the Nifty Index reaches your price target two days before expiry, the 16500 put could be worth 36; your gains could be 322 points (358 minus 36). In contrast, if you were to buy the 16400 call, your gains could be only 162 points (365 minus 203).
The difference in gains is not just from time decay favouring the short option. Consider this. If the Nifty Index reaches 16750 six days before expiry, the long 16400 call could provide gains of 214 points, 32 per cent more. But the short 16500 put could generate gains of 250 points, only 22 per cent lower than if the Nifty Index were to reach the price target two days before expiry.
This is because two factors work in favour of short options — delta and time decay. Note that delta — the change in the option price for a one-point change in the underlying — is a large number. An ITM put or call has an absolute delta greater than 0.50. We use the term “absolute” delta because puts have negative delta. This negative delta is to indicate that puts move in the opposite direction to their underlying; the absolute delta number is used for interpretation.
Now, the 16500 put has an absolute delta of 0.58. So, the 16500 put will lose 0.58 point for every one-point increase in the Nifty Index. Add to this the time decay factor and you have significant gains from short put. In contrast, the long 16400 gains from delta, but loses in time value (time decay). This explains for the likely increase in gains by 32 per cent if the Nifty Index were to reach the price target sooner than later.
The above argument does not mean that is optimal to short ITM puts (calls) compared to going long on ATM calls (puts) for a view that an underlying could go up (down). Shorting options are risky and require significant margin requirements. This is a strategy you could consider if you are comfortable shorting options and can manage the associated risk.
You should be mindful of the following before you short ITM options. One, check the strikes your broker will allow you to trade. Because of a cap in open interest for each underlying, brokers typically place restrictions on the strikes available for trading. At the time of writing this article, a leading broker allowed its customers to trade strikes between 15800 and 16750 on the next-week Nifty Index. Two, check the margin requirements on short option positions; for, margins are several times the premium collected. For instance, you collect a premium of 17900 on the 16500 short put, but your margins could be upwards of ₹1 lakh. Note that this margin requirement would reduce if you were to buy an OTM put against the short ITM put (bull put spread). But such strategies add a layer of complexity.
Note that liquidity is not an issue when it comes to shorting options; you are in no hurry to buy the option and close your short position if the underlying moves in your favour. If the underlying moves against your position, the strike you hold could be closer to ATM and, therefore, liquid. This will allow you to close your position and take losses.
(The author offers training programmes for individuals for managing their personal investments)