How butterfly spread can be a much easier solution than options trade

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undefinedWith a great deal of ease and convenience, Options do bring with themselves a certain set of difficulties. These difficulties may make options unattractive as an instrument to trade in certain situations. However, in such times I have always found shelter in an option strategy called Butterfly.

Let us discuss how certain peculiar situations can make Options unattractive to trade and how Butterfly Spread can be an easy solution.

Situation 1: When the underlying has been through, or even worse is going through a turmoil of constant downward spiral with sporadic pullbacks in between.

Here, I can quote an example of Yes Bank, just a few months back, when it collapsed from the levels of Rs 300.

The drop pushed the implied volatility to around 100 percent, making Options super expensive.

In such situations, one wouldn’t want to Buy futures because of potential loss, while any bargain hunting in Options may not be so effective due to:

a) The Options Premiums upfront are too expensive.

b) If and when the stock was to go higher, the risk premium in Option would reduce, not letting option rise to its fullest.

Situation 2: Trading a stale consolidation is difficult as, even though we do have straight forward strategies where one Sells both Call & Put to trade consolidation, we are running a huge risk of it terminating into a big move.

Once again, a recent example of Nifty where a more or less 300 points consolidation for three months, broke out of the range and pushed the index to a fresh high, in just a matter of days. In stocks, this could be even more violent.

Situation 3: Every option would seem more expensive to trade and cost dear to hold when the speed of time value decay is high. Typically, this would happen in the final days of expiry, when the absolute time value is lower in Options but a day on day decay is very high.

One may attempt to create spreads by selling a higher call/ lower put option, but if you choose a strike to sell too close, the profit gets limited, while choosing a farther strike, the premiums are too small to short.

Situation 4: Finally, while handling a known event and trying to tackle certain fall in risk premiums in the Options and thereby reduction in the Option premiums in totality.

I know the question this time is much bigger than the answer but these situations do present themselves time and again. The solution to all these issues is resorting to Butterfly. Butterfly spread can be created with the involvement of 3 strikes (for example 100,110,120) of same Expiry and same Option type (for example Call), where we Buy 1 Lot 100 Call + Sell 2 lots 110 Call + Buy 1 Lot 120 Call. There could be a variation of all Puts instead of Calls.

The variations are only to accommodate for liquidity otherwise involving same strikes do all Call/ all Put, both will give the same pay-off.

Pay-off: Maximum Profit with expiry @ centre strike, Max Loss beyond the 2 strikes Bought Max Profit = Strike Difference – net premium paid, Max Loss: net Premium Paid.

Now let’s see how Butterfly Spread is a solution to all the aforementioned situations:

1. For highly volatile stocks, Butterfly with initial outflow too low could be the best solution, because if the positional view turns right one gets a fairly favourable reward for the limited risk taken.

2. For stale consolidations, one may choose centre strike close to the current market price, in case of March expiry, like breakout in Nifty, the losses are predefined and limited to net Premium paid.

3. Choosing Butterfly in the final week of expiry can save us from an unlimited loss profile, as well as, help us in creating a trade with the least possible cost.

4. As far as events are concerned, having equal quantities of bought and sold options would take care of the drop-in risk premiums at the same time as mentioned in the first point, keeping the cost lower.

To sum up, these were some situations where Butterfly fits as a correct strategy.

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