Butterfly Options Trading Strategy
Butterfly is an exotic Options Strategy which can yield high returns against a very low probability of risk if executed correctly. Expert option traders around the world use this strategy to make money when the markets move sideways.
So, let us understand how Butterfly Strategy works, how you can take advantage of this strategy while trading and what are the associated risk that you have to take into account. If you have the necessary funds, then you can use the Butterfly Strategy to make money from the markets every month and run this strategy just like a business.
The risk-return profile of a Butterfly Strategy
As I mentioned earlier the Butterfly Strategy is a relatively safe option strategy through which you can make low-risk profits from the markets. This option strategy features:
- Low risk
- Low return
- Opportunity to make money from the decay of time value
Constructing the Butterfly:
Let us now understand how a Butterfly is constructed in a step-by-step manner.
Step 1: Buy call
Suppose the Nifty spot is at 8800. We are bullish on the market, so we buy a call which strike price of 8800 by paying a premium of Rs. 105.
| Option Type | Strike Price | Position | Premium Paid/Received | |
|---|---|---|---|---|
| 1 | Call | 8800 | Buy | -105 |
The payoff profile of this call at different market levels will be as follows:
| Spot Price | 8800 CE Buy | Total Payoff |
|---|---|---|
| -105 | ||
| 8500 | -105 | -105 |
| 8600 | -105 | -105 |
| 8700 | -105 | -105 |
| 8800 | -105 | -105 |
| 8900 | -5 | -5 |
| 9000 | 95 | 95 |
| 9100 | 195 | 195 |
| 9200 | 295 | 295 |
| 9300 | 395 | 395 |
| 9400 | 495 | 495 |
| 9500 | 595 | 595 |
As you can see, this position will give you unlimited profits when the market goes above the strike price of 8800. Potential loss from this position is limited to the premium paid, i.e. 105.
Step 2: Sell A Call
To limit the potential loss of 105, you can go ahead and sell the call of strike price which is slightly above 8800, i.e. 8900. The premium that you received by selling this call is 58 Rs. 58.
Now your position becomes:
| Option Type | Strike Price | Position | Premium Paid/Received | |
|---|---|---|---|---|
| 1 | Call | 8800 | Buy | -105 |
| 2 | Call | 8900 | Sell | 58 |
The combined payoff profile of these two positions becomes:
| Spot Price | 8800 CE Buy | 8900 CE Sell | Total Payoff |
|---|---|---|---|
| -105 | 58 | ||
| 8500 | -105 | 58 | -47 |
| 8600 | -105 | 58 | -47 |
| 8700 | -105 | 58 | -47 |
| 8800 | -105 | 58 | -47 |
| 8900 | -5 | 58 | 53 |
| 9000 | 95 | -42 | 53 |
| 9100 | 195 | -142 | 53 |
| 9200 | 295 | -242 | 53 |
| 9300 | 395 | -342 | 53 |
| 9400 | 495 | -442 | 53 |
| 9500 | 595 | -542 | 53 |
Now you can see that your profits and losses both have been limited Rs. 53 and Rs. 47 respectively. So this call sell position has effectively brought down your potential from Rs. 105 to Rs. 47.
Step 3: Sell another call
Next, you can sell another call of 8900 strike price at Rs. 58. So, now you hold 3 positions as follows:
| Option Type | Strike Price | Position | Premium Paid/Received | |
|---|---|---|---|---|
| 1 | Call | 8800 | Buy | -105 |
| 2 | Call | 8900 | Sell | 58 |
| 3 | Call | 8900 | Sell | 58 |
Look at the payoff profile of this combined position:
| Spot Price | 8800 CE Buy | 8900 CE Sell | 8900 CE Sell | Total Payoff |
|---|---|---|---|---|
| -105 | 58 | 58 | ||
| 8500 | -105 | 58 | 58 | 11 |
| 8600 | -105 | 58 | 58 | 11 |
| 8700 | -105 | 58 | 58 | 11 |
| 8800 | -105 | 58 | 58 | 11 |
| 8900 | -5 | 58 | 58 | 111 |
| 9000 | 95 | -42 | -42 | 11 |
| 9100 | 195 | -142 | -142 | -89 |
| 9200 | 295 | -242 | -242 | -189 |
| 9300 | 395 | -342 | -342 | -289 |
| 9400 | 495 | -442 | -442 | -389 |
| 9500 | 595 | -542 | -542 | -489 |
So as you can see, here again, the potential for making losses has become unlimited while limiting the profit potential. To limit the loss potential, you will have to execute the fourth and the final leg of the strategy.
Step 4: Buy another call
Next, you will buy the call at a strike price which is above the strike price at which you sold the two calls. Here, we go ahead and buy a call of strike price 9000 by paying a premium of Rs. 30.
So, you are combined Butterfly Strategy now looks like this:
| Option Type | Strike Price | Position | Premium Paid/Received | |
|---|---|---|---|---|
| 1 | Call | 8800 | Buy | -105 |
| 2 | Call | 8900 | Sell | 58 |
| 3 | Call | 8900 | Sell | 58 |
| 4 | Call | 9000 | Buy | -30 |
| Cost of the Butterfly | -19 | |||
The combined payoff profile becomes:
| Spot Price | 8800 CE Buy | 8900 CE Sell | 8900 CE Sell | 9000 CE Buy | Total Payoff |
|---|---|---|---|---|---|
| -105 | 58 | 58 | -30 | ||
| 8500 | -105 | 58 | 58 | -30 | -19 |
| 8600 | -105 | 58 | 58 | -30 | -19 |
| 8700 | -105 | 58 | 58 | -30 | -19 |
| 8800 | -105 | 58 | 58 | -30 | -19 |
| 8900 | -5 | 58 | 58 | -30 | 81 |
| 9000 | 95 | -42 | -42 | -30 | -19 |
| 9100 | 195 | -142 | -142 | 70 | -19 |
| 9200 | 295 | -242 | -242 | 170 | -19 |
| 9300 | 395 | -342 | -342 | 270 | -19 |
| 9400 | 495 | -442 | -442 | 370 | -19 |
| 9500 | 595 | -542 | -542 | 470 | -19 |
Thus, you can see that when the market remains range bound at around the 8900 levels, you will make a profit of Rs. 81. Favorite market moves sharply either upwards or downwards then you will make a limited maximum loss of Rs. 19.
Payoffs from this strategy
- Spread range: This is a range between the two strike prices, i.e. 100 in this example
- Maximum loss: Limited to the net premium paid to execute all the four legs of this strategy. This is called the cost of the Butterfly. It is Rs. 19 in this example.
- Maximum profit: spread range – cost of the Butterfly, i.e. (Rs 100 – Rs 19) = Rs 81.
As we already mentioned this is an exotic options strategy that can prove to be very handy when the market is expected to remain range bound. At Finideas, we conduct regular classes to teach Butterfly Strategy to option it is and we also execute the strategy ourselves for our clients. Feel free to join an options trading class if you want to gain in-depth knowledge of many such strategies.