Butterfly Options Strategy-Trading techniques frequently change when market volatility rises as traders attempt to predict their profitability. The most popular deal among traders is a pure vanilla option (1 strike Call or Put, buy or sell). Option traders, however, go from two-leg to four-leg tactics as volatility rises.
A trader can’t hold a two-leg strategy like a Bull Call Spread or Bear Put Spread in the present market, where the market has become extremely volatile with big intraday swings. Still, frequently it doesn’t appear worthwhile holding the position.
One approach that still appeals to people is the Butterfly; depending on how they see the market, they can purchase or sell it. Simply put, if someone has a bullish outlook, they can buy a Call Butterfly and if someone had a bearish outlook, they can buy a Put Butterfly.
What is Butterfly Options Strategy?
Options traders employ tactics called butterfly options strategy. Just keep in mind that an option is a type of financial instrument whose value is determined by the value of an underlying asset, such a stock or a commodity. By a defined expiration or exercise date, buyers are able to acquire or sell the underlying asset when using options contracts.
A butterfly options strategy combines a bull and bear spread, as was already mentioned. Four options contracts with the same expiration date but three distinct strike prices are used in this neutral strategy.
What is Long Butterfly Options Strategy?
A long butterfly options trading strategy consists of purchasing one call option at a lower strike price, selling two calls at a higher strike price, and then purchasing one call at an even higher strike price. The strike prices are equally spaced apart and all calls have the same expiration date.
How does it work?
1. Outlook
When one has a neutral outlook of the index or a stock.
2. Strategy
Let’s say Nifty is trading around 15,800 level, and a trader is having a bullish view on the market for 100 point or expecting the monthly derivative contracts to expire in the 15,800-16,000 band, near to 15,900.
So, to implement this butterfly options strategy, one need to:
- Buy 1 lot of Nifty 15,800 Call at Rs. 132.6
- Sell 2 lots of Nifty 15,900 Call at Rs. 82.65
- Buy 1 lot of Nifty 16,000 Call at Rs.46.4
3. Maximum loss\risk
In this butterfly options strategy, Risk is limited to the net debit paid.
4. Profit
The maximum profit potential can be obtained if the stock price is equal to the strike price of the short calls (centre strike) at expiration. This profit is equal to the difference between the lowest and middle strike prices less the net cost of the position including commissions.
5. Breakeven stock price at expiration
There are two break-even points for this butterfly options strategy-
- Strike A plus the net debit paid.
- Strike C minus the net debit paid.
6. Payoff Diagram
Below is the payoff diagram of the above strategy-
You can also read our blog on 12 Common Option Trading Strategies Every Trader Should Know
What is Short Butterfly Options Strategy?
A neutral strategy identical to Long Butterfly but bullish on volatility is Short Butterfly Option Strategy (also known as Short Butterfly). This method has a little potential upside and small potential downside.
The two long calls at the middle strike (or ATM) and one short call at the lower and upper strikes make up this strategy. The expiration dates of each option must match. Additionally, the centre strike must have equal distances from the upper and lower strikes (also known as wings) (or body).
How does it work?
1. Outlook
This strategy is intended for unique situations where you anticipate significant market volatility as a result of election results, budget announcements, policy changes, yearly result announcements, etc.
2. Strategy
You can implement the Short Call Butterfly by buying 2 ATM Call Options, selling 1 ITM Call Option and other OTM Call options. Please ensure that strike prices of Options are at an equal distance
3. Maximum loss\risk
The maximum loss is limited to Net Premium Paid
4. Profit
The net credit obtained less commissions represents the highest profit potential, and there are two ways that this profit could be made. All calls expire worthless and the net credit is retained as income if the stock price is lower than the lowest strike price at expiration.
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5. Breakeven stock price at expiration
There are two breakeven points. The stock price equal to the lower strike short call plus the net credit is the lower breakeven point. The stock price equal to the higher strike short call less the net credit is the upper breakeven point.
6. Payoff Diagram
Below is the payoff diagram of this strategy
Bottomline
To sum up, the butterfly technique is appealing to traders who desire to trade in a variety of market circumstances with consistent returns. The key thing to keep in mind is to follow the system while remaining disciplined to cut positions (profit or loss) and not get too greedy.
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