Some brokers do not allow their clients to buy deep out-of-the-money (OTM) strikes but may allow them to short these strikes. A SEBI-mandated disclosure that you read and agree when you login to your trading account tells you that nine of 10 traders incur losses trading options. Also, many market participants believe that options price-in high levels of volatility. These are several reasons traders are tempted to short options. This week, using option Greeks, we look at why shorting options may be risky, despite the likelihood of earning continual gains.
Delta and theta
An option’s delta is the important reason you gain from your option position. The delta is the change in the option price for a one-point change in the underlying price. So, if the underlying moves up 20 points, a call option price will move up too, determined by its option delta. But it is the gamma that determines how the delta moves. The gamma increases the speed of a call delta when an underlying moves up and reduces the speed when the underlying declines. At the outset, this appears beneficial for long positions and unfavourable for short positions.
But there is another factor to consider. When an underlying moves up, an option’s delta and gamma are beneficial, but the theta (time decay) works against the long position. When the underlying declines, the option’s delta and the theta work against the long position with only gamma working in its favour. As delta is a large number, a long call position loses significant value when the underlying declines. And losses to the long position means gains for the short position. There is, hence, a good reason for traders to short options. The gains can be significant, and the probability that an option will expire worthless is also high. So, why are short positions considered risky?
When the underlying dramatically moves up, your short call position will gather large losses. Such losses may be more than the gains you may have made in several short trades. So, managing your short position requires good discipline. The issue is that continual gains you make on your short positions may lure you into a sense of complacency, and you may fail to cut your losses when the underlying moves against you.
Optional reading
An optimal scenario for shorting is when the underlying has just slipped into a consolidation phase after a significant uptrend or downtrend. During this phase, the underlying can move slowly in the opposite direction to the prior trend or can move sideways. If it moves in the opposite direction, your profits will be greater because of gains from the option’s delta and theta. If price moves sideways, the gains will come primarily from theta. One disadvantage from this strategy is that an option’s implied volatility may not be high when an underlying is trending in one direction. So, the implied volatility’s contribution to time decay may be insignificant.
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