Today we are going to take about Butterfly as a option trading strategies.
Butterfly is a plain vanilla option strategy that is executed using 3 strikes on either CALLs or PUTs.All the strikes are equidistant(e.g.50-55-60; 100-120-140; 1000-1100-1200).
For long Butterfly we buy the outer strikes(wings) and sell the middle strike(body) and vice-versa, an example is given below with Nifty Call Butterfly.
In the above image we have bought 1 lot call of 10700 &10900 and sold 2 calls of 10800.As you can see in the image it’s a limited risk /limited return strategy.
Let us do the fun part – Quick calculation of our risk/return scenario.
- Maximum Risk = Calculate the net debit of the strategy and that is your maximum loss(excluding taxes and transaction cost).For the strategy discussed above- (117.5+28)-2*(61.15) = 23.2 is the maximum loss I can have in the strategy
- Maximum Profit = Difference between strikes-Maximum loss calculated above.For the strategy discussed above- 100(difference between strikes) – 23.2 = 76.8 is the maximum Profit I can have in the strategy on expiry.
- Break Evens = As you can see in the graph there are 2 breakevens in this strategy.Middle Strike +/- Maximum Profit– 10800+/-76.8 =10723.2;10876.8
- Tricks & Technique
- One should trade a butterfly as if the underlying is going towards the middle strike price slowly and staying there.
- Less the number of days, lesser the strike difference should be.
- If I have small expected risk/reward scenario, I will choose small difference in strikes.
- It’s not mandatory to trade only ATM butterfly.
- High volatility reduces the cost(initial debit) of butterfly.
- Execution of 3 leg order is a challenge(in Indian markets) and may incur slippages.
- It’s a combination of a ball spread and a bear spread.
- It works best near expiries.
Now let’s elaborate on this keeping various scenario in mind.We will use nifty in scenario building, which is currently at 10750 as on 23rd December 2018.
Days to expiry – Dec – 4 days, so I will choose strike difference of 50 or 100.If I am bullish, I will choose to do a call butterfly, and bearish then put butterfly. Had this been a January expiry which has 39 days to expiry I will use a strike difference of => 200.
Our confidence in expected moves are not always same(for discretionary traders),and we take position(size) accordingly.Similarly our expected risk/reward will guide the size of difference in strikes too.
Thanks for reading. Comments are welcome.
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