OTM butterfly for slow market: Shubham Agarwal!

Butterfly is one of the most celebrated strategies after the margin benefits were introduced. Butterfly strategy is a strategy adopted by many option sellers. However, little credit has been given to Butterfly by Option buyers who are more interested in directional moves. Before we go into its use, let us understand what the Butterfly strategy is.

Butterfly is a strategy that involves selling 2 options close to the current market price of the stock or index and buying a higher strike price option and a lower strike price option.

A butterfly made with all calls is called a Call Butterfly, and with all Puts is called a Put Butterfly. The favourite of option sellers is selling both Call and Put of strike close to the current market price and buying a Higher strike Call and a Lower strike Put. This is called Iron Butterfly. For directional trades, we will restrict ourselves to Call and Put Butterfly, and we will go OTM.

OTM or Out of the Money options are higher strike Call options and lower strike Put options. They are called OTM because if the stock had to expire exactly at the current price, these options would not make any money.

Now, let us look at the slow-moving market to understand how OTM Butterflies can help. A slow-moving market, especially in the first half of the monthly expiry, is very difficult for a directional option trader. Especially when the premiums are too expensive due to a lot of time-related value in them. The first problem is cost.

Second problem with these expensive options early in the expiry is that if it takes 2 weeks for the stock to move, the premium reduction due to passage of time is so severe that there is very little profit left for the trader despite the right call on direction. On the other hand, if we are towards the end of the expiry, the premiums are less expensive, but the loss due to the passage of time is very fast. In either case, the problem still remains of not being able to wait longer in the trade.

Both are critical problems to be dealt with. Both of them can be cleared by a Call/Put Butterfly depending on the direction.

Example of an OTM Call Butterfly

Let us say you are bullish on a stock trading at 1000 with a target of 1040

1010 Call @ 13

1040 Call @ 5

1070 Call @ 2

Now, the choice is to buy 1010 Call at 13 and sit on it. 1040 comes after 20 days, and with 2-3 days to expiry, the Option trades around 30. Profit of 17.

Or we create a Butterfly with Buy 1010, Sell 2 1040, and Buy 1070 Call. Ne Premium out is 5. Maximum profit = Diff between Buy and Sell strike (1040-1010 = 30) – Net Premium Paid (5) = 25.

Here, if we go wrong, we lose 5 vs losing 13 in the Call bought. Also, the strategy on the day of expiry is profitable after 1015, whereas the 1010 Call on expiry is profitable only after 1023.