Recently, we were asked an interesting question about options. If an individual trades with strict stop-loss, why should short option positions be considered risky? The argument is logical. This week, we discuss whether short option positions is less risky if the position is managed well.
Negatively skewed
The maximum gain from shorting options is the premium you collect when you initiate the position. This gain can be only realised if you hold the position till expiry, and the option expires worthless. The risk is higher if the underlying moves in the opposite direction.
With large percentage of contracts on the NSE expiring worthless, it is indeed tempting to short options. Added to this is the time decay (theta); options lose value with each passing day. Then, there is the Greek ensemble. When an underlying moves up, the call option price moves up, aiding by its Greeks, the delta and the gamma. Note that the delta plays a dominant role in determining a position’s gains, as it captures the approximate change in the option price for a one-point change in the underlying. But this factor works in favour of the short option position when an underlying moves down, as the delta turns negative. This means delta now works against the option position and along with theta pushes an option price down. Regardless of the direction of the underlying, gamma always works in favour of the long position. But gamma is a small number and is dominated by delta and theta.
The upshot? Several factors are stacked in favour of short positions. So, why then is shorting options considered risky? The reason has to do with negatively skewed returns distribution. Suppose you gain 85 out of 100 times you short options. These gains are limited to the premium collected. The remaining 15 times may see large losses. That means shorting strategies suffer from generating small frequent gains and large infrequent losses, unless you strictly manage your losses.
Position traders typically short options against other long positions such as long futures (switch trade) or long calls (bull call spread or ratio spread). Day traders go short and manage their naked short positions with strict price and time stops. If you are confident of taking your price stops intraday without suffering from loss aversion, then shorting options may not be as risky. But that is easier said than done.
Optional reading
Loss aversion refers to a behavioural bias that prevents us from taking losses; we hate losses much more than we like gains of the same magnitude. So, it is highly likely that loss aversion bias prevents you from taking your price stops on short options. Also, note that shorting (naked) options, being an obligation, requires large trading capital because of margin requirements. It is important that you do not get complacent, thinking shorting options is a good income generating strategy. It is risky, unless you take your stops, when required.
(The author offers training programmes for individuals to manage their personal investments)
Published on October 4, 2025
