The temptation to gain from time decay prompts many traders to short options during the contract expiry week, even though the position requires large margins. With effect from November 20, this margin requirement is set to further increase by two per cent on the contract expiry day. This week, we discuss the likely implication of this increased margin requirement on short option positions.
Short gains
There are several ways to capture time decay. The simplest yet the riskiest way is to set up a naked short position-short call or short put. Your gain comes from time decay and decrease in delta. Note that delta refers to the change in option price for a one-point change in the underlying. A decrease in option price leads to a decrease in delta. A conservative approach is to set up a spread position, adding a long option against the short option position. This would reduce the upside risk and margin requirements on the short option position, but involves additional cost of going long on the option.
From November 20, when the additional margin of two per cent will come into effect, would it be optimal to short options on the day of contract expiry? The answer depends on your conviction of the movement of the underlying asset. Why? Time decay is a function of the time value of an option. The time value consists of two components: time to expiry and implied volatility. Between the two, time to expiry is consistent in that it loses value with each passing day, as the option approaches expiry. Implied volatility can increase or decrease depending on the demand for the strike. An increase in implied volatility can increase option price through the option vega, whereas a decline in implied volatility can lead to a decline in option price through its delta.
But if your objective is to short an option, it is highly unlikely that you expect the implied volatility to decrease. This has implication for your trading. The closer an option is to expiry, lower the time value. Lower absolute time value will mean lower absolute gains from time decay. This is even more true on the expiry day. Add to this, the increase in margins from November 20, and it is moot if returns on your trading capital would be meaningful. Also, shorting options is a negatively skewed strategy. That is, you will make small frequent gains, but large infrequent losses if you fail to cut losses when the underlying shows adverse movement. That is why your conviction becomes even more important for the short position.
Optional reading
By increasing margins, SEBI hopes to moderate heightened option trading on contract expiry day. The measure appears warranted to prevent traders from shorting options without appropriately considering the associated risks. Increase in margins will lead to larger cash outflow. Though not a cost, higher margins could reduce the attractiveness to short options on contract expiry day.
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