Options trading | Expect a big move either way? Deploy 'Short butterfly'

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Nifty has been consolidating in a range of 350 points since the last month and a half, with volatility slipping to new lows. A formation like this is generally followed by a breakout on either side. Here's how you can go about it.

The Forecast

Traditionally, traders have spent a lot of effort in deciding the direction of the market to make returns from breakouts. But with options, you do not need to figure out the direction, as just the expectation of a breakout on either side can be used to build a strategy. This can be done in options, using the volatility strategies.

Volatility Strategies

The volatility long option strategy family has many permutations and combinations. The simplest ones could be buying a Straddle or Strangle, but in most of these strategies, the theta decay is large and if you hold the strategies for more than 3-4 days, the forecasting power can get diluted with the trade-off of theta decay.

If you expect volatility to evolve with some more time, strategies like Short Butterflies and Short Condors can be a better option. All volatility long strategies are limited risk, as net option trade is buying option and in almost all cases, you pay some theta decay.

Short Butterfly Strategy construction

A short butterfly consists of four legs of options trades. To initiate a short butterfly the choice is both using puts or calls and could also be a combination of calls and puts known as Iron butterflies.

A call butterfly would consist of selling 1 Lot of in the money call, buying 2 lots of ATM calls and selling 1 Lot of OTM Call. In this strategy, you are not net short options and hence, your risk is limited.

Expiry selection

Since in a short butterfly you are net-long on options, you would want the theta decay to be lowest. The right time to initiate this strategy will be when you have ample time to expiry, typically more than 10 days. If the nearest expiry is within 10 days you can initiate the strategy in the next expiry.

If the strategy does not work for a few days and expiry approaches, you can shift the strategy to the next expiry, this will cost theta but the cost will be optimized.

Volatility Impact

If the volatility in the market increases that is favourable for the strategy as the strategy is long vega. Since this strategy will mostly be initiated when the market has already been in a prolonged consolidation, the volatility at the time of trading the strategy is naturally low and the vega risk in the strategy is extremely low.

Odds remain high for the market to witness an increase in volatility and if that happens, it will benefit the strategy.

Variations to Strategy

The short butterfly can be adjusted to the market levels by shifting the distance between the legs. For e.g., if the breakout point is 200 points away but the breakdown point is just 100 points away, you can create a non-equidistant strike difference between the strategy legs to create a modified short butterfly.

Summary

Markets moving out from consolidations are also trading opportunities even if you are not sure of the next direction. This strategy can be well played with Short butterflies.

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