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How to gain from net time decay in derivatives – BusinessLine

Last week, we discussed a strategy involving shorting an ATM call and buying delta-hedged shares of the underlying or its futures contract. This strategy was set up to take advantage of a view that the underlying could move sideways through option expiry. The question is: Can a trader use deep in-the-money (ITM) calls instead of futures or the stock? This week, we discuss the characteristics of the strategy using ITM calls.

Time decay capture

We consider the 17400, the 17300 and the 17200 strikes to discuss this strategy, given that the Nifty Index currently trades at 17414. The argument for deep ITM call is simple. The total outlay for buying a deep ITM call is lower than buying a futures contract or the underlying asset. Also, the time value of a deep ITM call is significantly lower than that of an at-the-money (ATM) or an immediate ITM call of the same maturity.

Consider this. The 17400 call, deemed the ATM strike, has a time value of 113 points. The 17300 call for the same maturity has a time value of 74 points whereas the 17200 strike has only 47 points. So, why not buy the 17200 strike, and marry it with a short position in the 17400 strike if you expect the underlying to move sideways through expiry?

There are several factors to consider before you setup this strategy. There is a reason why time value reduces for ITM calls as you move far away from the current price of the underlying. These options carry high intrinsic value. The option price is, therefore, high and requires large outlay. This reduces the demand for these strikes. The reduced demand is reflected by a low time value of the option through low implied volatility. The 17200 strike had an implied volatility of 9.5 per cent compared to 9.92 per cent for the 17400 strike.

The reduced demand for these strikes also means that their prices are unlikely to align with the current price of the underlying. For instance, the 17200 call currently trades at 261 points. But if the index moves up 6 points to 17420, this price could continue to show 261 as the last traded price. But now, the time value would have declined to 41 points from 47 points. This is because time value is a residual factor- you deduct the strike’s intrinsic value from its option price. So, the issue is that the last traded price of the 17200 call relates to the index level of 17414, not 17420.

Then, there is the need to delta-hedge the position. Note that your objective is to neutralize the market direction (delta) and capture the time decay from the short call. For this, you must consider the delta of the 17400 call and that of the 17200 call. Based on the deltas, you should buy two contracts of 17200 call for every three contracts that you short of the 17400 call.

Option reading

Shorting an ATM call and buying a deep ITM call appears like a volatility arbitrage strategy. This is because you buy a low implied volatility strike and short a high implied volatility strike to create a position that benefits from net time decay. That is, the loss in time decay from the short option will be higher than the loss in time decay from the long option. For instance, if the index continues to trade sideways, the position could gain 18 points three days before expiry.

Of course, the profits will be lower when you use the deep ITM call instead of the underlying or its futures contract. That is because the long ITM call will also suffer time decay, unlike the underlying or its futures. But that is the cost you must incur as a trade-off for lowering your cash outflow by using deep ITM calls.

The author offers training programmes for individuals to manage their personal investments