If you have a view that an underlying is likely to trade sideways, you can set up short option positions. A sideways movement in the underlying translates into a bet that implied volatility is likely to implode (decrease). This week, we discuss factors to consider before choosing short calls or short puts. 

Time decay capture

A short call or a short put position captures gains from time decay. Time value is a function of time to expiry and implied volatility. You are likely to choose an option from strikes that expire on the same day. With the time to expiry the same for these options, the difference in their time value can be attributed to implied volatility. Note that higher the implied volatility, higher the time value. And higher the time value, larger the potential gains from time decay. Therefore, your choice of an option (call or put) must be based on which has higher time value. Your choice of a strike (at-the-money or out-of-the-money) must be based on which is more sensitive to volatility changes. 

You must consider two arguments — conceptual and empirical — to decide between shorting calls and puts. With the Nifty Index at 19601, the 19600 strike can be considered ATM using the rule that an ATM strike must be the one closest to the spot price. At current price levels, the 19600 call trades at 129 whereas the put trades at 108. Conceptually, it can be argued that calls ought to have a higher premium than puts because the upside in an asset is greater than the downside; for the upside is theoretically unlimited and the downside is bounded at zero. Of course, when you are trading for a given expiry date, this argument may not always hold water; for that depends on market expectations of the underlying during the remaining life of the option. This is the empirical angle to the argument.

Your choice between a call or a put should depend on two factors. Your primary factor should be to choose the option that has higher time value. Your secondary factor could be technical. If bulls fail to dominate despite the stock being closer to the resistance level, shorting a call could be worthwhile. Likewise, shorting puts may be gainful if bears fail to dominate despite the stock being closer to the support level.

When to short a call
If bulls fail to dominate despite the stock being closer to the resistance level, shorting a call could be worthwhile
Optional reading

A break below the support level could push an underlying further down, exposing the short put to high risk. Similarly, a break above the resistance level could expose the short call to high risk as the underlying could gather momentum. By shorting close to support or resistance level, you aim to capture handsome gains if the stock fails to break either of this level, or you can cut your losses quickly if the stock breaks this level. The next step would be to choose a strike most sensitive to changes in implied volatility — typically, the ATM strike.

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

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