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You must set up option strategies on strikes that have good liquidity (tradable strikes). This is important when you trade European options because you must sell the options to take profits if you want to close your position before expiry. But liquidity is not so important when you short options. This week, we discuss whether shorting the 50-strike options on the Nifty Index would be meaningful.
Implied volatility
When you short an option, your gains are primarily from time decay. This is the loss in time value of the option with each passing day. Would be it profitable to short the 50-strike options on the Nifty Index? This question is relevant because the 50-strike options are less liquid than the 100-strike options. For instance, at the time of writing this article, the 17500 strike had a volume of over 15,000 contracts within an hour of trading, whereas the 17550 strike had a volume of about 2,500 contracts. But liquidity is not important when you short options. Why? Because time value of an option is zero at expiry, your gains on the short options are the highest at expiry. Therefore, you are not compelled to close your short position before expiry and take profits. Hence, the reason to analyse the 50-strike options despite its low liquidity.
The time value of an option consists of two components — time to expiry and implied volatility. When you analyse strikes, you are often comparing strikes from the same expiry series. Therefore, the time to expiry of all the options must be the same. This means the difference in time value among these strikes can be attributed to implied volatility. Note that implied volatility is the volatility that is implied in the price of an option, given other variables to price the option.
The point is that implied volatility is a function of the option price. Take at-the-money (ATM) and out-of-the-money (OTM) options that have only time value. Suppose option traders demand an immediate OTM strike in anticipation of the Nifty Index moving up. This increase in demand could increase the option price. An increase in price will increase the option’s implied volatility.
If you want to set up a short call position just before the underlying turns after a continual uptrend, you must choose a strike that has high implied volatility. Often, these are strikes closer to the current spot price. Because of lower demand, the 50-strike options have lower implied volatility than the 100-strike options. This means your gains could be higher if you short the 100-strike options, provided your view on the underlying turns correct.
Optional reading
The decline in 50-strike options is lower than 100-strike options because of lower delta and demand. The fall in the 17450 strike is likely to be less than the 17400 strike if the index declines. So, if you were to set up a short position after the index turns, it could be worthwhile considering a 50-strike option.
The author offers training programmes for individuals to manage their personal investments
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