Most traders who call me to inquire about my course tell me that they know how to trade a butterfly. In fact this is first of the many trades they tell me they know. Strange it seems, but it looks like most Indian retail traders love to trade butterfly. Well frankly butterfly trade is not as easy as it seems and contrary to what many traders believe, it is a trade where some kind of prediction is required. Technically therefore it cannot be considered a non-directional trade.
Personally I stay miles away from a trade that needs any kind of prediction.
Do not get me wrong – a butterfly trade can be very profitable if the stock behaves the way the trader wants it to, but for that matter which trade does not make money if the view of the trader was right?
Anyway lets discuss the long call butterfly trade:
Traders view: If a trader believes the stock/index will be trading in the near term in a very narrow range, they can initiate a long call butterfly trade:
1. Sell 2 ATM (at the money) Call Option
2. Buy 1 ITM (in the money) Call Option for protection, and
3. Buy 1 OTM (out if the money) Call Option for protection.
All of the above options should have the same expiry date and of the same stock or index. Note that since 2 options were sold, 2 were also bought for protection.
Just like any other trade I explain in my website let me take a live example. Nifty on 12-Aug-2014 closed at 7727. So let me assume that for the next few days until August expiry, Nifty will remain range bound and will expire at around 7700.
Lets do some paper trading. Here is 12-Aug-2014 closing prices rounded off:
28-Aug-14 CE 7,700.00 107.00 (ATM) – We sell 2 lots
28-Aug-14 CE 7,600.00 178.00 (ITM) – We buy 1 lot
28-Aug-14 CE 7,800.00 55.00 (OTM) – We buy 1 lot
Lets do the long call butterfly trade:
1. Sell 2 7700 CE: 107*50*2 = +10700
2. Buy 1 7600 CE: 178*50 = -8900
3. Buy 1 7800 CE: 55*50 = -2750
Total money debit: 10700-8900-2750 = -950. This is the maximum loss this trade can have.
Lets examine the results on the expiry day:
Scenario 1) Nifty expires at 7700:
7700 CE expires worthless: +10700
7800 CE also expires worthless: -2750
7600 CE loss 78 points: -3900
Total profit: 10700-2750-3900 = Rs. 4050.00
ROI: Assuming Rs. 60,000 was blocked as margin for the whole trade. (Rs. 25,000 approx is blocked as margin for selling one lot of option. For 2 lots approx 50,000 will be blocked plus one ITM option was bought for 8900 – so the figure 60,000 was reached.)
(4050/60000) * 100 = 6.75% returns in 16 days. Excellent returns considering the number of days. Note that such an expiry is rare. So the profit depends on where exactly Nifty expires. 6.75% return is a gamble. 🙂
Scenario 2) Nifty expires at 8000:
7700 CE is 300. Loss: 300-107 = 193 * 50 * 2 = -19300
7800 CE is 200. Profit: 200-55 = 145 * 50 = +7250
7600 CE is 400. Profit: 400 – 178 = 222 * 50 = +11100
Total profit/loss: 11100+7250-19300 = -950
Scenario 3) Nifty expires at 7400:
7700 CE expires worthless: +10700
7800 CE also expires worthless: -2750
7600 CE also expires worthless: -8900
Total profit/loss: 10700-2750-8900 = -950
Conclusion: The reward though limited in the call butterfly is excellent if the prediction goes well and the stock expires very near the sold options. The risk is less compared to the reward. Unfortunately even though the risk-reward ratio is good in a call butterfly trade, the problem with the trade is predicting where the stock will be on the expiry day.
As a trader I am extremely averse to trades that need me to predict the direction of the markets. This particular trade needs predicting, so I do not trade butterfly.
Note that one can also do a put butterfly trade using only the put options and the results will still be similar. But for some strange reasons traders usually trade butterfly using call options.
Adjusting the butterfly:
You can rollover the butterfly upwards or downwards as the stock moves, but every time you do it there is a chance of losing money. Therefore rolling over is not a good adjustment to a butterfly. On top of that it will involve eight trades in every adjustment. This is not a good way to trade options.
So the best adjustment is to take a stop loss.
Now in real world scenario. How many times do you think in a 30-day period a stock or index will be trading in a very tight range? I do not see it doing in any 30 day period. A big movement will come someday or the other and the trader will have no option but to take a stop loss. I will go on to say that if you take a stop loss with every 100 point movement in Nifty, then for sure you will take it 100% of the times. You can never make money taking a stop loss or rolling over in this strategy.
Then what is the best way to play long call butterfly?
Basically a butterfly is a set it and forget it trade. Since risk is very small compared to the reward, a trader can set the butterfly trade and leave it till expiry. You already know your max loss, and if you are comfortable losing that money – just do not adjust. On expiry day if you are lucky, you can make a decent return. That is why the long call butterfly is more a gambling than a trade.
Another idea is to play it only on the expiry week. Traders can get some idea on where the stock may expire and those are the options that you may sell. For five days Nifty may be in a very tight range and there are high chances that this trade may be profitable.
Note that risk-reward is the same even in the expiry week, so trading this in expiry week makes sense.
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