Mastering Derivatives: When counterparties make money

A SEBI study about trading in the futures and options segment concluded that 89 per cent of traders incurred losses during FY22. This report prompted some readers of this column to ask whether shorting options would be more profitable. In response to this query, this week, we look at the characteristics of a short option trade.

Negative skewed strategy

Options trading is typically a zero-sum game. That is, a long position’s gain is a short position’s loss. So, if 89 per cent of traders suffered losses, does it mean that their counterparties were making gains? Yes, but we do not know whether the traders who suffered losses had only long positions. The loss-making trades could just as well be on both sides of the market (long and short). 

With most individuals’ trading options, the losses can be attributed primarily to two factors. One, the underlying could have moved adversely. This argument applies to both long and short positions. And two, despite the underlying moving as expected, the position could have lost because of time decay. This argument applies to only long positions. 

That said, it is generally true that long positions lose more frequently than short positions do. But the magnitude of losses is just as important, if not more. Empirical evidence shows that options often expire worthless. This ought to make shorting attractive. The issue is that short positions incur large losses when options end in-the-money. In other words, shorting options is a negatively-skewed returns strategy; you make frequent small gains (the option premium being the maximum gain) and infrequent large losses, unless you effectively manage your positions.

Stop-loss strategy

Stop-loss rule must be based on the underlying price for equity options and on the futures price for index options

But managing short positions is easier said than done. You must have a pre-determined rule to cut your losses if the underlying moves adversely. For short calls, this would mean the underlying moving up. For short puts, this would mean the underlying moving down. Your stop-loss rule must be based on the underlying price for equity options and on the futures price for index options.

Also read

Pricing options: Calendar days or trading days?

Mastering Derivatives: Using index futures to adjust portfolio beta

Mastering Derivatives: Arbitraging implied volatilities

Mastering Derivatives: When covered call comes to your rescue

Mastering Derivatives: Why not ITM strikes?

There is an alternative way to salvage your losses. Suppose you short the 19700 next-week Nifty call expecting the index to reverse from its current level of 19640. If the index were to move up instead, you could close the existing position and short a higher strike call, say, 19900. The number of contracts you short should be based on how confident you are of the overhead resistance level.

Optional reading 

You can significantly reduce your losses by having a simple rule — that you will short a call or a put only if you have a strong view on the underlying’s direction. Your view must be based on chart patterns, not on general reports that you read on the Internet or news development. Also, be mindful of the strike you short; a low probability of an option ending ITM (deep OTM strike, for instance) will mean small gains from time decay.

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