Options have asymmetric payoff: an option’s upside potential is greater than its downside risk. Take call options. The gains are greater as the underlying can increase sharply but the maximum loss is limited to the option premium even if the underlying declines sharply. This argument, however, does not consider the likelihood of generating gains from long positions. Many option strikes expire worthless. This provides ample opportunity for traders to short options. But shorting options is risky; potential gains is much less than the associated risks, as the asymmetric payoff works adversely for short positions. To moderate this risk, this week, we discuss a process to set up short positions.

Price exhaustion

Firstly, you must create a list of underlying assets which show weakening price trend. For instance, assets that have been on an uptrend for more than seven days could be part of your watchlist. This comes from the empirical evidence that suggests bulls typically have the resources to push up prices for not more than seven consecutive days. The same is true for downside movement.

Secondly, observe trading volumes of the underlying assets. A sharp increase in volumes after five-seven consecutive days of price increase could indicate bull exhaustion. The same argument applies for bear exhaustion.  

Thirdly, another indication of a weakening trend could be when the closing price of an underlying is far below (above) the highest (lowest) price for the day, and this happens after a sharp uptrend (downtrend). Also, observe the opening and the closing prices; the smaller the difference between these two prices, the weaker the trend.

Fourthly, your decision to initiate a short option position depends on your risk attitude. If you are an aggressive trader, you may want to initiate a short position immediately after the underlying trades below half the distance between the previous day’s high and low price. If you are a conservative trader, you want to wait for the underlying to close below the previous day’s low and initiate the trade the next day. Note that the aggressive position may allow you to capture larger gains as you would be initiating the short position at the start of a likely reversal. A conservative trade offers more confidence in the price reversal.

And finally , your choice of a call or a put option depends on the previous underlying trend. If the underlying has been climbing for a while, you must consider shorting calls. Likewise, if the underlying has been declining for a while, you must consider shorting puts. In either case, you must consider shorting the immediate OTM strike.

Assets watchlist
Put assets on uptrend on your watchlist as evidence suggests bulls have resources to push up prices for not more than seven days
Optional reading

Your gains from short call or short put will come from theta or time decay as the option will lose value due to passage of time. In addition, as the underlying declines, immediate OTM calls become more OTM. This will add to your gains through the option delta. The same argument applies for OTM puts when the underlying moves up.

The author offers training programmes for individuals for managing their personal investments

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