Butterfly Option Strategy & Adjustments | Management | Nifty Live Example | Bear Call Spread

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In this video we would learn about the most popular options strategy in the trading world, the butterfly spread and also a few ways to adjust the setup.

Butterfly Spread Option Strategy:

A long butterfly spread is the purchase of one option at a lower strike price X1, the purchase of another option at a relatively higher strike price X2 and the sale of two options at a strike price that is halfway between X1 and X2.

A short butterfly spread is the sale of one option at a lower strike price X1, the sale of another option at a relatively higher strike price X2 and the purchase of two options at a strike price that is halfway between X1 and X2.

The options are of the same type, have the same underlying, and have the same expiration date. The halfway strike price is usually close to the current spot price of the underlying.

The short butterfly spread is the opposite of a long butterfly spread. While the long butterfly is a range bound strategy, the short butterfly is a volatility strategy.

That is, while the short butterfly profits from a big move in the underlying, the long butterfly is profitable when there is little or no movement in the underlying.

For the purposes of this video, let us limit our discussion to long butterfly spreads.

The long butterfly spread owes its popularity to its high reward - risk ratio. But high reward strategies are usually associated with low probabilities of success. This is true for butterfly spreads too, as they have a narrow range of profit.

A long butterfly spread is a net debit trade and can be initiated at a very low cost. The maximum loss at expiry is the debit paid to enter the spread, while the maximum profit at expiry is the difference between the adjacent strike prices minus the debit paid.

The maximum profit is achieved when the underlying closes exactly at the strike price of the short options.

There are two break even points. The lower break even point is equal to the lower strike price (X1) plus debit paid; the higher break even point is equal to the higher strike price (X2) minus debit paid.

Example:

Nifty is at 9860 on June 16th, 2020. A long call butterfly spread can then be entered as follows:

Buy one lot of 25th June 9700 strike price Call at 293.45
Sell two lots of 25th June 9900 strike price Call at 181.75
Buy one lot of 25th June 10100 strike price Call at 100.95

Calculations:

Maximum loss at expiry = Debit paid to enter the spread = [293.45 + 100.95 - (2 x 181.75)] x 75 = 30.9 x 75 = ₹2317.5

Maximum profit at expiry = Difference between adjacent strike prices - Debit paid to enter the spread = (200 - 30.9) x 75 = 169.1 x 75 = ₹12682.5

Lower break even point = Lower strike price + Debit paid to enter the spread = 9700 + 30.9 = 9731

Upper break even point = Upper strike price - Debit paid to enter the spread = 10100 - 30.9 = 10069

The margin required to initiate this strategy is about ₹30k and the capital required is about ₹60k. The probability of profit is about 24%, which is pretty low.

Risk Graph:

From the risk graph of the long call butterfly spread it is evident that the profit range is narrow and that explains the low probability of profit of the strategy. The maximum profit and the maximum loss at expiry are ₹12682.5 and ₹2317.5 respectively. The two break even points are at 9731 and 10069.

Adjustments:

Say, about 4 trading days left to expiry, Nifty dropped to 9750.

The first adjustment would be to add another butterfly spread to the tested side with the lower strike of the original butterfly spread as the middle strike.

This would leave us with an Iron Condor kind of setup.

The said adjustment would widen the profit range and enhance the probability of profit but the risk would increase.

The second adjustment would be to add a bear call spread to the untested side at the same strikes as the middle strike and the higher strike of the original butterfly spread.

This would leave us with a modified call butterfly kind of setup.

The said adjustment would remove the entire risk on the tested side but would increase the risk on the untested side.

The third adjustment would be to add a bull put spread to the tested side a strike or two below the lower strike price of the original butterfly spread along with adding a bear call spread to the untested side at the same strikes as the middle strike and the higher strike of the original butterfly spread.

This can also be seen as adding an iron condor above the original butterfly setup.

The said adjustment would widen the profit range but would increase the risk on both the tested and the untested sides.