Chapter 9: What is Going Long & Short in Options?
Similar to futures trading, options traders use various jargon to express their views in the market. They use terms like going long or going short whenever they have a bullish or bearish view respectively. Let’s decode these terms in this Chapter.
Going Long and Short in Options
In general, trading involves two main positions: “ Going Long ” and “ Going Short”.
These terms might sound confusing while trading in options at first, but they’re essentially bets on the price movement of a particular stock, index, or any other underlying assett.
In futures trading, going long and going short is fairly easy to understand but in options there are multiple ways to go long and go short.
To summarise, here’s a table that will show you how long and short positions can be created in options.
- You can take a long position by either buying a call option or shorting/selling a put option.
- You can take a short position by either buying a put option or shorting/selling a call option.
Going Long vs Going Short
Going Short on the other hand, means having a bearish bias and your expectation is that the price of the underlying asset might fall. A trader can create a Short Position by either going long meaning buying a Put Option or by shorting a Call Option meaning Selling/writing a Call Option.
As you can see, the long positions and short positions on an options contract can express either a bullish or bearish sentiment depending whether the trader goes long in a call or put option or the trader also has an choice to go short and express the same bullish and bearish sentiments.
Lets take some examples to simplify this concept further. Just the next 5 mins and youll be absolutely clear with these terms.
1. Going Long with Options
- Buy a call option
- Sell a put option
Long Call
Imagine you’re optimistic about the future of Infosys aka “INFY” a tech company, and you think its stock, currently trading close to 1400 levels, will rise in the next few months
You decide to go long by purchasing a call option with a strike price of rs 1400 and an expiration date three months from now by paying a premium of lets say 50 rs.
This call option gives you the right to buy Infys’s stock at Rs. 1400 at expiry.
If Infys’s stock price indeed rises to Rs. 1600 at expiry, you could buy the stock at 1400 (as per the option contract ) and then immediately sell it at rs 1600 in the market, pocketing a 150 profit per share. (Spot Price Rs 1600 – Strike Price Rs 1400 – Premium paid Rs 50 = 150/- Net profit * lot size 400 = Rs 60,00/- profit)
Short Put
Another way of creating a long position is to Short a put Option. Instead of buying a call option of infy you can sell a Put option to create a long position in Infosys.
Lets say the spot price of infy is the same , trading at 1400. You can sell an ATM put of 1400 strike price trading at rs 55. Now since your shorting a put option , your profit potential is restricted.
And as we have learnt Chapter 3 – Option premium pricing , since the difference between exercise price and spot price cannot be negative , therefore the premium is the profit for the option seller.
Remember we had discussed that the reason why option sellers make profit is that when an option expires OtM , the time value that an option premium has goes down to zero and the seller gets to keep it as profits.
And since Infys 1400 put option became OTM ( since spot price > strike price ) as an option seller , you made a profit of Rs 22,000/-
Summary:
2. Going Short in Options
There are 2 ways of taking a long position with options.
- Buy a Put Option
- Sell a Call Option
Going short with options can indicate 2 things.
- Going short can mean your bias is bearish (here we are referring to as taking a bearish bias on the underlying asset)
- You can only make profits when the price of the underlying asset “Falls“
Let’s take some examples on how you can create short positions with options.
Long Puts
Imagine you have a bearish view on HDFC Bank, the largest banking stock which is currently trading 1500 and you are expecting a fall in the stock prices on the coming months.
So you can create a Short Position by Going Long in Put Options
You decide to Long Put meaning, to buy a Put Option of the strike price of 1500 which will expire in the next 2 months, at a premium of let’s say Rs. 30. This Put option gives you the right to sell the HDFC bank stock at the same price of Rs. 1500 at expiry.
Now, say you view was right and the stock price goes down to Rs. 1300.
So the put option you bought gave you the right to Sell HDFC bank at rs 1500. And since the price at expiry has fallen as anticipated , you can exercise your put option so that you can buy HDFC Bank at Rs 1300 from the market and sell it to the put option seller at Rs 1500. Thus pocketing Rs 93,500/- Rs profit.
Similar to the infy example where we had the choice to short put option to go long , there’s another way by which you can also take a short position in HDFC Bank ie. by selling a call option.
Short call
With the same bearish view in mind , instead of buying a put option, you can create a short position by selling a Call Option.
Here the strike price is the CMP which is 1500 and the premium is let’s say Rs 30.
Summary:
Option Buying Vs Option Selling
Now one can argue which is best , option buying or option selling. Both have their pros and cons.
Option buying seems to be a safer choice since the profit potential is unlimited while the loss is always limited.
Option Selling on the other hand is risky but the probability of sellers making is higher (as we learnt while studying the option premium pricing Chapter).
When you go Short in options, you have the potential to make limited profits, or the prices fall sharply or if the price goes up, while your risk is unlimited as you are selling options.
Conclusion
Traders, all the above examples discussed, show various ways of going long and short involving option buying as well as option selling to execute the trades.
The only thing that is different was the risk reward ratios which is:
Option buyers will always have limited risk and unlimited return potential. By selling options, a trader will always have a limited profit potential whereas the loss potential can be unlimited.
As you can see in our examples discussed above:
While taking a Long or Short Position , Option Buying seemed to rationally a better choice since profitability indeed seems better given the fact that the risk was limited.
But theres always an inherent risk to option buying which we all know pretty well by now , which is – ( you guessed it right ) “theta decay“.
If the prices remained sideways , option buyers will loose the premium that has been paid to the option sellers.
While option sellers have the risk of having a strong momentum which could go against them. Hence forcing them to exit their short positions ( short squeeze ) and hitting their stop losses, ultimately leading to losses!
So which is better , both option buying and option selling have the potential to make money but the fact is , it totally depends on the risk profile of the trader and also how well a trader follows risk management.
If you are someone who is risk averse then option buying could be better choice. Whereas if you are someone who wants to take high probability trades and is willing to take calculated risk , then Option Selling is a better choice.
A gentle disclaimer here, although option selling is one of the most lucrative forms of trading, it’s indeed challenging. This is mainly because option selling has unlimited risk potential, remember we have discussed this in our earlier we explained why traders sell options.
Remember, options trading involves risks, and the potential for profit comes with the potential for loss.
It is therefore important to have a good understanding of the market, strategies, and risk management before engaging in options trading.
Always start with small positions if you’re a beginner and gradually increase your exposure as you gain more experience.
With this we come to an end of this Chapter. In the next Chapter we will learn how can we use Option Greeks to our advantage while trading in options.
See you in the next one!