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With market at record high, account for both greed and gear with modified Call Butterfly

After a couple of gyrations in the range I believe Modified Butterfly could be the best way to trade upcoming gyration along with accounting for an end of it

SHUBHAM AGARWAL | 22-Dec-19
Reading Time: 3 minutes

undefined Trading at the Top is oftentimes a little tough as both greed and fear are at play with equal force. On one hand, we are anxious to cash in on the much-anticipated break out into uncharted territories and on the other hand, there is sheer acrophobia due to the gains already posted by individual stocks and indices.

Such are the times when every trading bet needs to accommodate for a sudden turn of tide, and at the same time, be open to making money in case of an erratic move. Hence textbook strategies like ratio spreads, which are highly economical, would not work as the risk profile in case of an erratic move would be extremely unfavorable, and neither would the text book directional butterfly strategy work as they would manage the risk well but would yield into losses.

Let us examine both these issues and figure out how the modified butterfly turns out to be a cheaper alternative to this peculiar situation.

Consider a situation where the indices have reached up to recent highs, giving us an indication that there could be a pause and a range that the indices might get stuck into. In such a situation, the next round of upward gyration is expected to be played with.

For this a Butterfly strategy is apt. Especially with the weekly expiries now available for trading, deploy a Butterfly strategy with center strike at the expected and empirically proven upper bound or lower bound.

A Butterfly strategy is where we sell 2 Calls/ 2 Puts depending upon the upward or downward move expectation and buy a lower strike Call/Put and a higher strike Call/Put at equal distance. The maximum profit would be with expiry at the center strike. Maximum profit would be the difference between the buy and sell strikes minus the premium paid at the time of initiation.

This is perfect for a slow-moving market. However, there is still a possibility of the upper bound being taken out in the upcoming gyration. If that happens, the Butterfly strategy would still yield a loss beyond the bought strikes.

Let us see an example of and try to seek a solution out of this. Assume Bank Nifty is at 32,000. Now to trade a move towards the upper band at 33,000, one would resort to a butterfly with following trades:

Buy 1 lot 32,300 CE @ 190Sell 2 lots 33,000 CE @ 55

Buy 1 lot 33,700 CE @ 15

Maximum profit = 700 (Difference between strikes) – 95 (190 – 110(55 *2) + 15) = 605

Maximum Loss = 95

This is how it will outperform another directional strategy, but it will create things unprofitable if there is a big move beyond 33,700.

Now, we want all the good from this trade i.e. the inexpensiveness, yet want to keep the upside open. In such situation, the Butterfly can be modified by reducing the difference between the strikes on the side where we want the profit not to turn into loss.

So here, a modified Butterfly could be deployed. Let us try modify the aforementioned trade.

Buy 1 lot 32,300 CE @ 190Sell 2 lots 33,000 CE @ 55

Buy 1 lot 33,300 CE @ 30 (modification.)

Maximum profit = 700 (Difference between strikes) – 95 (190 – 110(55 *2) + 30) = 590

Maximum loss = 110

There is a slight twist. Because of the nearing of the upward strike from 33,700 to 33,300 now above 32,300 wherever Bank Nifty goes there will be at least a constant profit = 400 (reduced difference between the strike sold above) – 110 (Premium Paid) = 290.

After a couple of gyrations in the range, I believe the Modified Butterfly could be the best way to trade the upcoming gyration, along with accounting for an end of it.

Learn and read more about option chain from Quantsapp classroom which has been curated for understanding of derivatives from scratch, to enable option traders grasp the concepts practically and apply them in a data-driven trading approach.

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SHUBHAM AGARWAL is a CEO & Head of Research at Quantsapp Pvt. Ltd. He has been into many major kinds of market research and has been a programmer himself in Tens of programming languages. Earlier to the current position, Shubham has served for Motilal Oswal as Head of Quantitative, Technical & Derivatives Research and as a Technical Analyst at JM Financial.

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