Butterfly: A tool to trade safe in a highly volatile market

Asia's Tech News Daily

Butterfly strategy, Nifty50, nifty, Trading strategies, Nifty Trading strategies

When volatility increases in the market, trader tend to switch strategies to gauge their payoff. In the normal course, a plain vanilla option (1 strike Call or Put, buy or sell) is the most favourite trade among the traders. But when volatility increases, option traders switch from two-leg to four-leg strategies.

In current market situation where the market has turned highly volatile with large intraday swings, a trader can’t hold a two-leg strategy like a Bull Call Spread or Bear Put Spread, where losses and profits are limited, but many a time it doesn’t seem worth holding the position. One strategy which is still seems attractive is Butterfly; one can buy or sell it depending on his/her view of the market. In a basic term, if one is having a bullish view, then s/he can buy a Call Butterfly and in the case of a bearish view, s/he can buy a Put Butterfly.

What is Butterfly?

Let’s say Nifty is trading around 17,800 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 17,800-18,000 band, near to 17900.

Butterfly strategy, Nifty50, nifty, Trading strategies, Nifty Trading strategies
ETMarkets.com

Butterfly strategy, Nifty50, nifty, Trading strategies, Nifty Trading strategies
ETMarkets.com

So the total cost involved in this Butterfly is Rs 10, whereas the maximum benefit in this strategy can be (gap of strike, which is 100 minus cost (100-10) is Rs 90 if Nifty expires at 17,900. If the trader is holding the view that the market would expire beyond the 17,800-18,000, then s/he can sell the Butterfly to receive the whole premium on the expiry of the contract.

Benefits over normal spread (bull call and bear put)

If the expiry is far, then we can see less sensitivity in the price of the Butterfly compared with the normal spread. Let’s understand it with an example.

Butterfly strategy, Nifty50, nifty, Trading strategies, Nifty Trading strategies
ETMarkets.com
(The above table suggests the sensitivity of the different option strategy with movement of underlying and days expiry)

In nutshell, a Butterfly can hedge against huge intraday volatility and wide movement compared with any other strategies.

How to select the Butterfly

There are various factors involved in selecting the Butterfly like, time to expiry, range and expectation (sideways or trending). If the time to expiry is more, then we can expect the less movement in the Butterfly compared with the vertical spread or plain vanilla option. If a trader wants to cover a wider range, then he has to pay more premiums. The bigger the gap between strikes of a Butterfly, the more the premium one has to pay.

Let understand all these points with examples:

Example 1, Mr. A want to cover the nifty range of 17800-18000.

Buy: 17800 call 1 lot at 167

SELL: 17900 call 2 lots at 114

BUY 18000 call 1 lot at 74

Example 2, Mr.B expecting the range of 17800-18200

Buy: 17800 call 1 lot at 167

SELL: 18000 call 2 lots at 74

BUY 19200 call 1 lot at 26

The premium paid by Mr B is higher, as it covers a bigger range and both views are bullish. The trend defines whether to buy or sell a bullish (Call Butterfly) or bearish (Put Butterfly) strategy.

How to select strikes and set profit & loss

The best way to select a Butterfly is by taking the strike at 1 standard deviation of the underlying inside the range. Let’s understand it with an example. Say Nifty spot level is 17,700 and the 1 Standard deviation is 200 point. Then we need to cover the range of 17,900 (17,700+200) and 17,500 (17,700-200) in Nifty. The best Butterfly to execute is 200 points nifty 17,700 Butterfly.

Profit payoff always attract traders, but it’s quite tough to achieve it fully. The best way to book profit is time target, price target or one can book profit on approximately 5-8 per cent of the capital deployed, which is quite reasonable in the long run. The stop loss should be an underlying price if the trader is taking a bet on technical analysis. If he is using derivative data, then he should wait until the data get reversed, whether or not price level breached.

To conclude, Butterfly is an attractive strategy for those traders who want to trade in all kind of market conditions with consonant payoff. The only thing one should keep in mind is to remain disciplined to cut position (profit or loss) and not become too greedy while following the system.

(DK Aggarwal is the CMD of SMC Investment and Advisors)

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