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Previously in this column, we discussed why taking positions in options are better if you are betting on price reversals. This week, we discuss why calls have a marginal edge over puts when you are betting on price reversals.
Delta variation
Betting on options for price reversals are preferable to futures. Your loss on options is restricted to the premium paid, whereas futures have symmetrical payoffs. Therefore, buying calls when you expect an underlying to arrest its downtrend and move up could be gainful. Likewise, buying puts if you expect the underlying to stop its uptrend and decline thereafter could be profitable.
Your gains from options come from two sources — increase in price because of intrinsic value and implied volatility. Suppose an underlying has been continually declining and you believe the trend will reverse. You decide to buy an at-the-money (ATM) call. If the underlying turns and moves up, the call delta will increase sharply because of two factors. One, the ATM option will now become in-the-money (ITM) because it will carry intrinsic value. And two, the change in direction will increase the implied volatility of the call. So, gains on the call could be high.
The permitted lot size for the contract will act as a multiplier, as you are likely to take profits before expiry. Suppose you buy one contract on an underlying (permitted lot 100). If the option gains 10 points and you close the contract before expiry, your profit is 1,000 (100 times 10).
The question is: Do calls and puts behave in the same manner when the underlying moves in the preferred direction? Suppose the Nifty is at 17100 and you buy the next-week 17100 call for 178 points. If the Nifty Index moves to 17300 three days before expiry, the call could be worth 239 points for a gain of 61 points. Suppose you buy the 17100 put, say, for 178 points. If the index declines to 16900 (same 200-point reversal), the 17100 could be worth 235 points for a gain of 57 points.
The difference is marginal. But the above argument only approximates the actual movement. The difference could be greater if the increase in the implied volatility of calls is greater than that of puts. That depends on whether the demand for calls is greater than that of puts (which it typically is). Note that an increase in demand for an option will feed into its price through time value. And the time value of an option consists of time to maturity and implied volatility. That means greater the demand for a strike, higher its implied volatility.
Optional reading
As a useful approximation, suffice it to know that the delta of a call minus the delta of a put must be equal to one (especially for a non-dividend paying stock). The delta of a call whose strike is equal to the spot price of the underlying is marginally greater than 0.50. Therefore, delta of a put of the same strike must be marginally smaller than 0.50, as both the absolute deltas must add to one. Because you are betting on gains from delta and implied volatility on price reversals, calls have a marginal edge over puts as it has greater delta. Of course, this marginal edge may not matter if you are generating gains from both calls and puts.
The point of the above discussion is this: You must prefer set-ups for momentum trades. This is because failure of reversals (false signals) is likely to be greater compared to failure of price momentums (false breakouts). If want to set up option positions for reversals, then consider setting up calls (or call spreads) to bet on a price reversal to the upside. Setting up puts (or put spreads) to bet on a price reversal to the downside is only the next preference.
The author offers training programmes for individuals to manage their personal investments
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