Last week, we discussed how to decide between a short call and a short put for a view that the underlying is likely to move sideways. We suggested that you choose an at-the-money (ATM) call or a put whichever has higher time value. The second rule related to how close the underlying’s price was in relation to the support or the resistance level. But what if the gap between the support and the resistance level is wide and the underlying trades between the two levels? This week, we discuss how to determine whether to short a call or a put in such cases.

Managing losses

Suppose the support on the Nifty Index is 19040 and the resistance is 19640. With the index currently at 19320, the resistance level is 320 points away and the support level 280 points away. It may seem that further the resistance or the support level is from the current price, the better it is for the option position; the underlying must break the resistance or the support level to gain momentum. So, the argument could be to set up a short call (short put) if the resistance (support) is farther away from the price compared to the support (resistance) level. There is, however, another factor to consider.

You are likely to short an ATM or the immediate out-of-the-money (OTM) strike. This is because a sideways movement in an underlying is also a view that implied volatility is likely to implode (decrease). As ATM strike has the highest vega, it is likely to lose more in time value when volatility decreases. Note that gains for the short position comes from loss in time value. 

The issue is that if the index is exactly at the support or the resistance level, your short position will gather losses as the option will become in-the-money (ITM). Therefore, you must first decide whether a short position will benefit despite an underlying reaching its support or resistance level. You must then short a call or a put, whichever is likely to give more gains. 

Before you short
You must decide whether a short position will benefit despite an underlying reaching its support or resistance level, before shorting a call or a put
Optional reading

The next-week 19300 put trades at 105 points and the 19350 call at 128 points. You should not set up a short position because the potential loss from intrinsic value is larger than gains from time decay if the index reaches 19640 or 19040. But suppose the put were trading at 330 and the call at 370, the put will lose 260 points from intrinsic value if the index were at 19040 at expiry but will gain 330 points from time decay. The call will lose 290 points from intrinsic value if the index were at 19640 at expiry, but will gain 370 points from time decay. Hence, choosing the call may be optimal. Not that the short position could have losses or lower gains if the underlying moves to the resistance or the support level before expiry, as the option will carry time value.

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