Setting up short positions is efficient in the derivatives market compared with the spot market. But within the derivatives market, which is more efficient: options or futures? This week, we discuss two factors you must consider when deciding between shorting options and futures — margins and expected returns.
The trade-off
Futures have symmetrical payoff. That means futures move nearly one-to-one with the underlying on the upside and the downside. Options do not move one-to-one with the underlying. But options offer asymmetric payoff — upside potential is greater than downside risk. This argument, however, holds for only long option positions. For short position in calls, the maximum gain is much lower than the maximum loss; the maximum gain is restricted to the option premium collected at the time of initiating the position.
This leads us to the first factor. The expected return on futures is the difference between the short futures price and the price target. You must compare this with the premium collected on the short call and typically prefer the position that offers you higher expected return. But there is additional factor to consider for options. The time value of an option becomes zero at expiry. This is important because one source of return on your short call is time decay, which refers to the decline in time value with each passing day. This means the maximum gain on your short call can be achieved only at expiry. But what if the underlying hits your price target well before expiry? You will have to buy the option to close your short position. This means lower gains compared with achieving the price target at expiry.
Then, there is the second factor. Futures, whether long or short position, requires initial margin. Long option positions require upfront premium, but short options require initial margin. These margin requirements are large. For instance, a short position on the near-month 19700 Nifty call will require about ₹1.10 lakh, similar to the margin requirement on the near-month Nifty futures contract. Given that the margin requirements are not significantly different, you must consider the return in relation to the capital employed for the strategy. Given that the maximum gain on short call is restricted to the premium, it could be optimal to setup short futures position instead of a naked short call position.
Optional reading
You could control the high risk of a naked short call by setting up a bear call spread (short lower strike call, long higher strike call). A bear spread will carry lower risk and lower initial margin because the short call is covered by the higher strike long call. But the expected gains will also be lower, just the net credit. If you are a frequent trader with disciplined approach to taking losses, short futures position is typically preferable; it provides one-to-one movement with the underlying and does not depend on whether the price target is reached immediately or at expiry.
The author offers training programmes for individuals to manage their personal investments