Mastering derivatives: short put or long call?

A reader of this column wanted to know how a trader should decide between taking a long call and short put position in order to gain a positive view of the underlying asset. Accordingly, this week we discuss how to choose between the two setups.

Possible gains

You must use two steps to determine whether a long call or a short put offers larger potential gains for a given positive view of an underlying asset. First you need to select a call and a put for comparative analysis. The call should be a tradable strike price just above the spot price to allow room for the option to become in-the-money (ITM) and still not lose liquidity if the index rises. With the Nifty index at 17651, this could be the call from 17700. Note that if the index were at 17627, you would still choose the 17700 strike since the 50 strikes of the Nifty Index are illiquid; Liquidity is important to sell the option and take profits. For the put, you should preferably choose the at-the-money (ATM) strike, as it yields greater profits from time decay than an OTM put. Also, the ATM strike is the most sensitive to a fall in implied volatility. Note that a fall in implied volatility favors short positions and discourages long positions. Based on the option delta, the 17700 put is considered an ATM.

Second, you need to determine the potential gains for both the call and the put, assuming that the underlying asset will reach your target price when the option expires. The longer it takes for an underlying to reach your price target, the lower the profits on your long call. This is because the call loses time value with each passing day. So if the long call is profitable at expiry, it should be more profitable anytime before expiry. This is because when you sell the take profit option, you can capture the time value. The short put generates maximum profits at expiration when the option expires out of the money (OTM). Interestingly, if the underlying moves up quickly, the short put can achieve similar gains as the long call; the gains can be attributed to a decreasing delta and faster time decay.

The result: You should prefer short puts if you expect the underlying asset to move slowly until the option expires. Otherwise, when the potential gains are similar, choosing between a long call and a short put will depend on your risk preference, since a short put exposes you to large losses if the underlying asset falls.

Observe

You need to determine the potential gains for both the call and the put, assuming that the underlying asset will reach your target price when the option expires

Optional reading

With a long call position, there is a risk that the target will not be reached before expiry despite an upward movement in the underlying asset; The loss from time decay will be greater than the gains from delta accelerated by gamma. The risk of a short put position is that the underlying asset could fall; The loss due to the increase in delta will be greater than the gains due to the decrease in time.

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