If liquidity is important to options trading, why do analysts recommend short selling out-of-the-money (OTM) options, where liquidity is usually an issue? In this article, we explain why liquidity is more important for long positions than for short positions.
Short against long
When you buy an option, you are betting on the option that generates intrinsic value gains. In other words, if you buy an OTM option, you benefit from intrinsic value if the option becomes in-the-money (ITM). Alternatively, you can profit from an increase in the delta if the option continues to remain OTM even as the underlying increases. Note, however, that your long position will continue to lose time value with each passing day. Thus, the gain in intrinsic value or the increase in the delta must be large to dominate the losses due to time decay.
Shorting an option is different. The decay of time is a natural process. That is, an option will lose value whether the underlying moves up or down. However, you should be concerned about the underlying movement against your position. If you sell a call option, you don’t want the underlying to go up. And if you sell a put option, you don’t want the underlying to go down.
Take Nifty index. Suppose you shorted next week’s 17500 call for 102 points. If the Nifty Index rises from its current level of 17315, then the 17500 call will gather more activity. And that means greater liquidity. So you can close your short option if the underlying moves against your position. On the other hand, if the Nifty index continues to fall, the 17500 call will lose its liquidity as it becomes deep OTM. But that’s not a problem because the option will lose time value as it nears expiration. So, in the worst-case scenario where the option you sell becomes illiquid, you can continue the position until expiration, at which point you would have made your gains; note that your maximum gain is the premium collected when you sell the option short.
Liquidity is a function of the demand for an option. The demand for an option is based on where the strike price is relative to the underlying price. As a general rule, the closer the strike price is to the underlying price, the higher the demand will be, especially if it is out of the money (OTM). It is in this context that you should consider shorting deep OTM strikes or going long on ITM strikes.
While liquidity is not a problem for short positions, premiums are. The larger the OTM option you sell, the lower the premium you will receive. For example, the 17800 call traded at 31 points, almost half the premium of the 17600 strike. Certainly, the likelihood of such options ending in the money (ITM) is low. You may have to sell multiple contracts short to collect a large premium. Or you have to settle for lower earnings in exchange for the slim possibility that the strike will end ITM.
You should observe the accumulation of open interest on Nifty weekly options (calls and puts) to infer the opinion of market participants on the underlying. Generally, it can be argued that if the 17400 call has the maximum increase in open interest, market participants expect the Nifty Index to close below 17400. The logic behind this interpretation is that sophisticated traders usually write call (call) options. And short selling is only profitable if the underlying is below the strike price. You can choose a tradable strike above that strike to increase the chances of the option expiring worthless. Traders prefer to sell options closer to expiration. Indeed, the temporal decrease accelerates as an option approaches expiration; because the time value must become zero on expiration. The flip side is that the time value will be small with less time remaining until expiration.
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