If liquidity is important to options trading, why do analysts advise short out-of-the-money (OTM) deep options, where liquidity is usually an issue? In this article, we discuss why liquidity is important in long positions compared to short positions.

short vs long

When you buy an option, you are betting that the option generates gains from intrinsic value. That is, if you buy an OTM option, you gain from the intrinsic value if the option becomes in the money (ITM). Alternatively, you can take advantage of the increase in delta if the option remains in the OTM even if the underlying moves up. Note, however, that your long position will continue to lose its time value with each passing day. Therefore, the gain of intrinsic value or increase in delta must be large to control losses from time decay.

Short selling is a different option. Time waning is a natural process. That is, the option will lose its value whether the fundamentals move up or down. However, you should be concerned about the fundamental move against your position. If you sell a put option, you do not want the underlying to move higher. And if you sell a put option, you don’t want the underlying asset to go down.

Take the Nifty indicator. Let’s say you sell a 17,500 call for the next week for 102 pips. If the Nifty rises from its current level at 17315, the 17500 call will gather more activity. This means greater liquidity. Therefore, you can close out your put option in case of fundamental moves against your position. On the other hand, if the Nifty continues to fall, then the 17,500 demand will lose liquidity because it will become a deep OTM. But this does not cause a problem because the option will lose its time value as it approaches maturity. Therefore, in the worst case scenario where the option you are selling becomes illiquid, you can hold the position until expiration at which time you would have made your gains; Note that the maximum profit is the premium charged at the time you short the option.

Liquidity is a function of the demand for an option. The demand for the option depends on where the strike is located in reference to the underlying price. Typically, the strike is closer to the underlying price, and demand increases, especially if it is out of the money (OTM). In this context, you should offer to short sell deep OTM strikes or continue to execute ITM strikes.

While liquidity is not an issue for short positions, premiums do. The deeper the OTM option, the lower the premium you will receive. For example, the 17,800 buy traded at 31 pips, which is roughly half of the 17,600 strike premium. It is true that the probability of such options expiring in the money (ITM) is low. You may have to shorten several contracts to collect a large premium. Or you should settle for lower gains in exchange for a lower probability of ending the ITM strike.

Optional reading

You should note the accumulation of the open interest on the weekly Nifty options (buys and sells) to derive the market participants’ view of the basis. Normally, it can be said that if the 17400 call has a maximum increase in open interest, then market participants expect the Nifty to close below 17400. The logic behind this interpretation is that premium traders are usually short (writing) call options. Short selling is only profitable if the underlying is below the strike. You can choose one tradable strike above this strike to improve the odds of the option expiring worthless. Traders prefer selling options as expiration approaches. This is because time decay accelerates as the option approaches expiration; The time value should become zero at expiration. The flip side is that the time value will be small with less time left until expiration.

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