Previously in this column, we discussed how to apply the implied volatility rule and the liquidity rule to set up a long call position. This week, we discuss the necessary conditions to short put options when you have a positive view on the underlying.
Options have asymmetric pay-off. That is, your potential profits are higher than the potential losses for a long position because the maximum you can lose is the premium you pay to buy an option. The opposite is true for a short position. So, the maximum profits you can earn by shorting options is the premium, while your potential loses are higher. Given limited profits and higher losses, it is important to satisfy two conditions before you consider shorting puts when you have a positive view on the underlying.
The first condition has to do with implied volatility, a factor that we use to determine whether an option is trading cheap or rich. In this case, you want the puts to trade rich (overpriced) because you want to set up a short position. So, check if the underlying has been on a downtrend in recent times, say, within the last one month. If so, puts should be in good demand. Note that higher demand for options will result in higher implied volatility, which we explained while discussing the implied volatility rule.
Now, if you expect the underlying to stop its declining trend and turn upwards, demand for puts should fall. The fall in demand should lead to decline in implied volatility and, therefore, fall in the option price. Note that you can earn the maximum profit only if the put option you short is worth zero at expiry.
Given that the put has to move towards zero for a short position to be profitable, apply a reverse implied volatility rule. That is, pick three strikes — the ATM option, one immediate ITM option and immediate OTM option– and choose the one with the highest implied volatility. Then, apply the liquidity rule– check if the strike you chose has high change in open interest.
You are now ready to short a put, provided the second condition is satisfied. This relates to the put premium. Suppose you expect the underlying to move up 50 points. Your objective should be to capture close to 50 points by shorting puts. You should, therefore, short a put whose premium is greater than the upside potential (50 points in the above case) and also has high implied volatility. That way, when the underlying moves up, this put could swiftly moves towards zero. If these two conditions are not met, you should not short puts when you have a positive view on the underlying; you should instead set up a long call position.
Theta or time decay favours a short put position. So, higher the time value of the option, greater the benefit from shorting a put option if the above two conditions are met. Since implied volatility is the reason why one strike will have higher time value than another for the same underlying and same maturity, you should choose the one with the highest implied volatility. Note that time decay for ATM option is high during the last week of expiry.
If you dabble in options, you may be familiar that long option position often loses value. Logically then, a short option position should typically earn profits. This empirical evidence could tempt you to short options.
So, it is important that you understand that shorting options is a negatively-skewed strategy. This means you will earn small profits frequently but suffer large loses infrequently. Also note that you have to post margins for your short positions. Finally, prior experience in options trading is important for managing short positions, especially if the underlying moves against you exposing you to large losses.
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