Short Call Butterfly Option Trading Strategy

Nilesh Jain

27 Mar 2017

A Short Call Butterfly is implemented when an investor is expecting volatility in the underlying assets. This strategy is initiated to capture the movement outside the wings of the options at expiration. It is a limited risk and a limited reward strategy.

When to initiate a Short Call Butterfly?

Short Call Butterfly can generate returns when the price of an underlying security moves moderately in either direction. It means that you don’t have to forecast the trend of the market, but you have to bet on volatility. When the implied volatility of the underlying assets is low and you expect volatility to shoot up, then you can apply Short Butterfly Strategy.

How to construct a Short Call Butterfly?

A Short Call Butterfly can be created by selling 1 ITM call, buying 2 ATM call and selling 1 OTM call of the same underlying security with the same expiry, giving the trader a net credit to enter the position. Strike price can be customized as per convenience of the trader but the upper and lower strikes must be equidistant from the middle strike.

Strategy Sell 1 ITM Call, Buy 2 ATM Call and Sell 1 OTM Call
Market Outlook Movement on or above the sold strike price & Bullish on volatility
Motive Attempt to correctly predict the movement in underlying assets in either direction
Upper Breakeven Higher Strike price of short call Net Premium Received
Lower Breakeven Lower Strike price of short call + Net Premium Received
Risk Limited (Maximum loss only if expires at middle strike)
Reward Limited to Net premium received
Margin required Yes

Let’s try to understand with an Example:

Nifty Current spot price (Rs) 8800
Sell 1 ITM call of strike price (Rs) 8700
Premium received (Rs) 210
Buy 2 ATM call of strike price (Rs) 8800
Premium paid (Rs) 300(150*2)
Sell 1 OTM call of strike price (Rs) 8900
Premium received (Rs) 105
Upper breakeven 8885
Lower breakeven 8715
Lot Size 75
Net premium received (Rs) 15

Suppose Nifty is trading at 8800. An investor Mr A enters a Short Call Butterfly by selling 8700 call strike price at Rs 210 and 8900 call for Rs 105 and simultaneously bought 2 ATM call strike price of 8800 @150 each. The net premium received to initiate this trade is Rs 15, which is also the maximum possible reward. This strategy is initiated with a view of moderate movement in Nifty hence it will give the maximum profit only when there is movement in the underlying security either below lower sold strike or above upper sold strike. Maximum loss from the above example would be Rs 6375 (85*75) if it expires at middle strike. The maximum profit would only occur when underlying assets expires below 8700 or above 8900 i.e. Rs 1125 (15*75). Another way by which this strategy can give profit is when there is an increase in an implied volatility. For the ease of understanding, we did not take in to account commission charges. Following is the payoff chart and payoff schedule assuming different scenarios of expiry.

The Payoff Chart:


The Payoff Schedule:

On Expiry NIFTY closes at Net Payoff from 1 ITM Call Bought (Rs.) Net Payoff from 2 ATM Calls Sold (Rs.) Net Payoff from 1 OTM Call Bought (Rs.) Net Payoff (Rs.)
8200 210 -300 105 15
8300 210 -300 105 15
8400 210 -300 105 15
8500 210 -300 105 15
8600 210 -300 105 15
8700 210 -300 105 15
8715 195 -300 105 0
8800 110 -300 105 -85
8885 25 -130 105 0
8900 10 -100 105 15
9000 -90 100 5 15
9100 -190 300 -95 15
9200 -290 500 -195 15
9300 -390 700 -295 15
9400 -490 900 -395 15

Impact of Options Greeks before expiry:

Delta: The net delta of a Short Call Butterfly spread remains close to zero.

Vega: The Short Call Butterfly has a positive Vega. Therefore, one should buy Short Call Butterfly spread when the volatility is low and expect to rise.

Theta: With the passage of time, if other factors remain same, “Theta” will have a negative impact on the strategy, because option premium will erode as the expiration dates draws nearer.

Gamma: The Short Call Butterfly will have a short gamma when it is initiated.

How to manage risk?

A Short Call Butterfly requires experience in trading, because as expiration approaches small movement in underlying stock price can have a higher impact on the price of a Short Call Butterfly spread. Therefore, one should always follow strict stop loss in order to restrict losses.

Analysis of Short Call Butterfly spread strategy

A Short Call Butterfly spread is best to use when you are confident that an underlying security will move in either direction. This is a limited reward to risk ratio strategy for advance traders.


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Why to Choose Mutual Funds Instead of Directly Investing Into Equities?

Whether to invest in equities or mutual funds is a question that has plagued every investor. As someone who needs the best value for his/her investment should you invest in equity directly or via mutual funds?

Let’s start by first understanding what these two terms ‘equities’ and ‘mutual funds’ stand for-

Equities- Equities generally represent ownership of a company. If you own any equity in a company, you are a part owner of the said company (depending on how much equity you own).

Mutual Funds – It is an investment scheme which is professionally managed by an asset management company. It pools together the resources of a group of people and invests their money in equities, debentures, bonds and other securities.

Why choose mutual funds over equities?

For people who’ve never invested in either stocks or mutual funds, it is hard to know which is better and where to start. Broadly speaking, if you are a novice investor, mutual funds are not only less risky but also way easier to manage. Here are some ways in which investing in mutual funds is beneficial as opposed to investing in equities -

Diversification

Mutual funds provide more diversification as compared to an individual equity stock. When you invest in equity, you are investing in a single company which has its inherent risk. For example, if you invest Rs.20,000 in buying equities of one company, you could face a total loss if that particular company performs poorly in the market.  

If you invest the same amount in mutual funds, it will be invested in different kinds of stocks and financial instruments, high-risk and low-risk both, so you might not face total loss even if one company does poorly.

Scale of Investment and Lower Costs

For an individual investor buying and selling stocks is a difficult task due to its high price. Thus, any gains made from stock appreciation are nullified if the overall trading costs are considered. Comparatively with mutual funds, as the money is pooled from a large number of investors, the cost per individual is lowered.  

Another advantage of mutual funds is that you don’t need to invest large sums of money. Buying equities for a profitable venture needs huge amounts of money, a minimum of few lakhs. With mutual funds, you can start with Rs.1000 and earn profits on that as well.

Convenience

Keeping an eye on the markets everyday is a time-consuming business, especially if you are investing as a side gig. There are people who spend their lives studying the market and still end up sustaining heavy losses. Though investing in mutual funds does not guarantee high returns, it is stress-free and needs less work as compared to investing in equities.

To sum it up

It is important to remember that mutual funds have their own disadvantages as well. Thus, as with any financial decision, educating yourself and understanding the suitability of all the available options is the ideal way to invest. 


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Short Call Butterfly Option Trading Strategy

Nilesh Jain

27 Mar 2017

A Short Call Butterfly is implemented when an investor is expecting volatility in the underlying assets. This strategy is initiated to capture the movement outside the wings of the options at expiration. It is a limited risk and a limited reward strategy.

When to initiate a Short Call Butterfly?

Short Call Butterfly can generate returns when the price of an underlying security moves moderately in either direction. It means that you don’t have to forecast the trend of the market, but you have to bet on volatility. When the implied volatility of the underlying assets is low and you expect volatility to shoot up, then you can apply Short Butterfly Strategy.

How to construct a Short Call Butterfly?

A Short Call Butterfly can be created by selling 1 ITM call, buying 2 ATM call and selling 1 OTM call of the same underlying security with the same expiry, giving the trader a net credit to enter the position. Strike price can be customized as per convenience of the trader but the upper and lower strikes must be equidistant from the middle strike.

Strategy Sell 1 ITM Call, Buy 2 ATM Call and Sell 1 OTM Call
Market Outlook Movement on or above the sold strike price & Bullish on volatility
Motive Attempt to correctly predict the movement in underlying assets in either direction
Upper Breakeven Higher Strike price of short call Net Premium Received
Lower Breakeven Lower Strike price of short call + Net Premium Received
Risk Limited (Maximum loss only if expires at middle strike)
Reward Limited to Net premium received
Margin required Yes

Let’s try to understand with an Example:

Nifty Current spot price (Rs) 8800
Sell 1 ITM call of strike price (Rs) 8700
Premium received (Rs) 210
Buy 2 ATM call of strike price (Rs) 8800
Premium paid (Rs) 300(150*2)
Sell 1 OTM call of strike price (Rs) 8900
Premium received (Rs) 105
Upper breakeven 8885
Lower breakeven 8715
Lot Size 75
Net premium received (Rs) 15

Suppose Nifty is trading at 8800. An investor Mr A enters a Short Call Butterfly by selling 8700 call strike price at Rs 210 and 8900 call for Rs 105 and simultaneously bought 2 ATM call strike price of 8800 @150 each. The net premium received to initiate this trade is Rs 15, which is also the maximum possible reward. This strategy is initiated with a view of moderate movement in Nifty hence it will give the maximum profit only when there is movement in the underlying security either below lower sold strike or above upper sold strike. Maximum loss from the above example would be Rs 6375 (85*75) if it expires at middle strike. The maximum profit would only occur when underlying assets expires below 8700 or above 8900 i.e. Rs 1125 (15*75). Another way by which this strategy can give profit is when there is an increase in an implied volatility. For the ease of understanding, we did not take in to account commission charges. Following is the payoff chart and payoff schedule assuming different scenarios of expiry.

The Payoff Chart:


The Payoff Schedule:

On Expiry NIFTY closes at Net Payoff from 1 ITM Call Bought (Rs.) Net Payoff from 2 ATM Calls Sold (Rs.) Net Payoff from 1 OTM Call Bought (Rs.) Net Payoff (Rs.)
8200 210 -300 105 15
8300 210 -300 105 15
8400 210 -300 105 15
8500 210 -300 105 15
8600 210 -300 105 15
8700 210 -300 105 15
8715 195 -300 105 0
8800 110 -300 105 -85
8885 25 -130 105 0
8900 10 -100 105 15
9000 -90 100 5 15
9100 -190 300 -95 15
9200 -290 500 -195 15
9300 -390 700 -295 15
9400 -490 900 -395 15

Impact of Options Greeks before expiry:

Delta: The net delta of a Short Call Butterfly spread remains close to zero.

Vega: The Short Call Butterfly has a positive Vega. Therefore, one should buy Short Call Butterfly spread when the volatility is low and expect to rise.

Theta: With the passage of time, if other factors remain same, “Theta” will have a negative impact on the strategy, because option premium will erode as the expiration dates draws nearer.

Gamma: The Short Call Butterfly will have a short gamma when it is initiated.

How to manage risk?

A Short Call Butterfly requires experience in trading, because as expiration approaches small movement in underlying stock price can have a higher impact on the price of a Short Call Butterfly spread. Therefore, one should always follow strict stop loss in order to restrict losses.

Analysis of Short Call Butterfly spread strategy

A Short Call Butterfly spread is best to use when you are confident that an underlying security will move in either direction. This is a limited reward to risk ratio strategy for advance traders.


Have Referral Code?