Broken Wing Butterfly is slow but steady strategy in making money amid volatility

Reading Time: 3 minutes

Making medium-term commitments has two major essentials. First, one needs to have the conviction on a rather long-range forecast (Long Range Trading more often than not is 15-20 sessions).

Second, and rather difficult essential is that the patience and ability to hold on to the trade through all possible thick and thin.

What we mean by ability is that the drawdowns could be lethal in terms of underlying movements. Options Trading strategies needs to account for all possible draw-downs and our willingness to make peace with all those possible adversities is imperative.

Now, in normal situations, we would stop here with a simple solution of Buying a Call for a Bullish forecast or a Put for Bearish forecast but amid the COVID-19 led eruption in volatility the Option premiums have skyrocketed, leaving little on table for us despite of the view being right. In other words, option premiums are elevated, implied volatility associated is high.

For example: In normal situation Nifty 8,100 Call which is closest to the closing on April 3, 2020 would be about 144 instead the closing price is 472. So, to defeat this expensiveness one strategy that comes really handy is Broken Wing Butterfly. To understand this let’s understand first what Butterfly option strategy is.

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 Buy & Sell strikes minus the premium paid at the time of initiation.

This is perfect option trading strategy for a consolidating market, however, there is still a possibility of the upper or lower bound being taken out in the upcoming gyration. If that happens the Butterfly option strategy would still yield a loss beyond the bought strikes.

Let us see an example of April 3, 2020 and try to seek a solution out of this. Nifty closed at 8,083. Now to trade a move towards 7,500 one would resort to a butterfly with the following trades.

Buy 1 Lot 8,000 PE @ 429Sell 2 Lots 7,500 PE @ 258

Buy 1 Lot 7,000 PE @ 144

Maximum Profit = 500 (Difference between strikes) – 57 (429 – 516(258 *2) + 144) = 443

Maximum Loss = 57

This is how it will outperform another directional option strategy, but it will create things unprofitable if there is a big move beyond 7,000. But, we want all the good from this trade i.e. the inexpensiveness, yet want to keep the upside open.

In such a 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 a loss this modification makes Butterfly, a Broken Wing Butterfly options strategy.

So here a Broken Wing Butterfly option could be deployed. Let us try to modify the aforementioned trade. Buy 1 Lot 8,000 PE @ 429Sell 2 Lots 7,500 PE @ 258

Buy 1 Lot 7,200 PE @ 180 (Modification)

Maximum Profit = 500 (Difference between strikes) – 93 (429 – 516(258 *2) + 180) = 407

Maximum Loss = 93

There is a slight twist. Because of the nearing of the lower strike from 7,000 to 7,200 now below 7,200 wherever Nifty goes there will be at least a constant profit = 200 (reduced difference between the strike sold above) – 93 (Premium Paid) = 107.

In case the move towards center comes before expiry there would still be trading profits. Thus, ‘Broken Wing Butterfly’ is slow but steady in making money and one of the most inexpensive ways to trade.

Disclaimer: The views and investment tips expressed by investment experts on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.

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

To know more about Quantsapp tools, signup here https://web.quantsapp.com/signin .