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Chapter 9 Volatility Option Strategies

Volatility Option Strategies

Volatility Option Strategies are made use by traders when they expect huge swing in the price of the underlying asset in either direction. The trader tends to bet on the surge in volatility rather than the trend. Following are the most popular strategies that can be used when the volatility is expected to spike in the underlying asset.

How to make Profit in a Volatile Market at low cost - Long Strangle Option Strategy

A Long Strangle strategy is one of the simplest trading strategies, which can be used to make profit in an extremely volatile market. A Long Strangle is a slight modification of the Long Straddle strategy and also cheaper to execute as both the calls and puts are Out-the-Money. It can generate good returns when the price of an underlying security moves significantly in either direction. It means that you don’t have to forecast the trend of the market, but you have to bet on the volatility.

When to initiate a Long Strangle?

If you believe that an underlying security is going to make a move because of any events, such as budget, monetary policy, earning announcements etc, then you can buy OTM call and OTM put option. This strategy is known as Long Strangle.

How to construct a Long Strangle Option strategy?

Long Strangle is implemented by buying Out-the-Money call option and simultaneously buying Out-the-Money put option of the same underlying security with the same expiry. Strike price can be customized as per convenience of the trader but the call and put strikes must be equidistant from the spot price.

Strategy Buy OTM Call and Buy OTM Put
Market Outlook Significant volatility in underlying movement
Motive Capture a quick increase in implied volatility/ big move in underlying assets
Upper Breakeven Strike price of Long call + Net Premium Paid
Lower Breakeven Strike price of Long put - Net Premium Paid
Risk Limited to Net premium paid
Reward Unlimited
Margin required Limited to the premium paid

Let's try to understand with an example:

Nifty Current spot price Rs 8800
Buy OTM Call Strike Price Rs 9000
Premium Paid (per share) Rs 40
BUY OTM Put Strike price Rs 8600
Premium Paid (per share) Rs 30
Upper breakeven 9070
Lower breakeven 8530
Lot Size 75

Suppose, Nifty is trading at 8800. An investor Mr A is expecting a significant movement in the market, so he enters a Long Strangle by buying 9000 call strike at Rs 40 and 8600 put for Rs 30. The net premium paid to initiate this trade is Rs 70, which is also the maximum possible loss. Since this strategy is initiated with a view of significant movement in the underlying security, it will give the maximum loss only when there is very little or no movement in the underlying security, which comes around Rs 70 in the above example. Maximum profit will be unlimited if it breaks the upper and lower break-even points. Another way by which this strategy can give profit is when there is an increase in implied volatility. Higher implied volatility can increase both call and put’s premium.

For the ease of understanding, we did not take in to account commission charges. Following is the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY closes at Net Payoff from Call Buy (Rs) Net Payoff from Put Buy (Rs) Net Payoff (Rs)
8300 -40 270 230
8400 -40 170 130
8500 -40 70 30
8530 -40 40 0
8600 -40 -30 -70
8700 -40 -30 -70
8800 -40 -30 -70
8900 -40 -30 -70
9000 -40 -30 -70
9070 30 -30 0
9100 60 -30 30
9200 160 -30 130
9300 260 -30 230

Impact of Option Greeks:

Delta: The net delta of a Long Strangle remains close to zero. The positive delta of the call and negative delta of the put are nearly offset by each other.

Vega: A Long Strangle has a positive Vega. Therefore, one should buy Long Strangle spreads when the volatility is low and expect it 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: Gamma estimates how much Delta of a position changes as the stock prices changes. Gamma of the Long Strangle position will be positive since we have created long positions in options and any major movement on either side will benefit this strategy.

How to manage risk?

A Long Strangle is exposed to limited risk up to premium paid, so carrying overnight position is advisable but one can keep stop loss to further limit losses.

Analysis of Long Strangle spread strategy

A Long Strangle spread strategy is best to use when you are confident that an underlying security will move significantly in a very short period of time, but you are unable to predict the direction of the movement. Maximum loss is limited to debit paid and it will occur if the underlying stocks remain between the two buying strike prices, whereas upside reward is unlimited.

How Long Straddle Option Trading Strategy can be used for making profits in a volatile market?

A Long Straddle Options Trading is one of the simplest options trading strategy which involves a combination of buying a call and buying a put, both with the same strike price and expiration. Long Straddle option strategy can be used to make profit in a volatile market. It can generate good returns when the price of an underlying security moves significantly in either direction. It means that you don’t have to forecast the trend of the market, but you have to bet on the volatility.

When should you initiate a Long Straddle Option Trading?

If you believe that an underlying security is going to make a move because of events such as budget, monetary policy, earning announcements, etc., and also implied volatility should be at normal or at below average level, then you can buy call & put option. This strategy is known as long straddle trading.

How should you construct a Long Straddle Option Strategy?

Long straddle options strategy is implemented by buying at-the-money call option and simultaneously buying at-the-money put option of the same underlying security with the same expiry.

Strategy Buy ATM Call and Buy ATM Put
Market Outlook Significant volatility in underlying movement
Upper Breakeven Strike price of buy call + Net Premium Paid
Lower Breakeven Strike price of long put - Net Premium Paid
Risk Limited to Net premium paid
Reward Unlimited
Margin required No

Let’s try to understand this with an example:

Nifty Current spot price Buy ITM/ATM Call+ Sell OTM Call
Buy ATM Call & Put (Strike Price) Rs. 8800
Premium Paid (per share) Call Rs. 80
Premium Paid (per share) Put Rs. 90
Upper breakeven Rs. 8970
Lower breakeven Rs. 8630
Lot Size (in units) 75

Suppose, Nifty is trading at 8800. An investor, Mr. A is expecting a significant movement in the market, so he enters a long straddle by buying a FEB 8800 call strike at Rs. 80 and FEB 8800 put for Rs. 90. The net premium paid to initiate this trade is Rs. 170, which is also the maximum possible loss. Since this strategy is initiated with a view of significant movement in the underlying security, it will give the maximum loss only when there is no movement in the underlying security, which comes around Rs. 170 in the above example. The maximum profit will be unlimited if it breaks the upper and lower break-even points. Another way by which this options trading strategy can give profit is when there is an increase in implied volatility. Higher implied volatility can increase both call and put’s premium.

For the ease of understanding, we did not take into account commission charges. Following is the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY closes at Net Payoff from Call Buy (Rs) Net Payoff from Put Buy (Rs) Net Payoff (Rs)
8300 -40 270 230
8400 -40 170 130
8500 -40 70 30
8530 -40 40 0
8600 -40 -30 -70
8700 -40 -30 -70
8800 -40 -30 -70
8900 -40 -30 -70
9000 -40 -30 -70
9070 30 -30 0
9100 60 -30 30
9200 160 -30 130
9300 260 -30 230

Analysis of Long Straddle Options Trading Spread Strategy

A Long Straddle Spread Strategy is best to use when you are confident that an underlying security will move significantly in a very short period of time, but you are unable to predict the direction of the movement. Downside loss is also limited to net debit paid, whereas upside reward is unlimited.

Short Put Ladder Strategy Explained

Short Put Ladder Strategy

A Short Put Ladder is the extension of Bull Put spread; the only difference is of an additional lower strike bought. The purpose of buying the additional strike is to get unlimited reward if the underlying asset goes down.

When to initiate a Short Put Ladder

A Short Put Ladder should be initiated when you are expecting big movement in the underlying asset, favoring downside movement. Profit potential will be unlimited when the stock breaks lower strike price. Also, another opportunity is when the implied volatility of the underlying asset falls unexpectedly and you expect volatility to go up then you can apply Short Put Ladder strategy.

How to construct Short Put Ladder?

A Short Put Ladder can be created by selling 1 ITM Put, buying 1 ATM Put and buying 1 OTM Put of the same underlying asset with the same expiry. Strike price can be customized as per the convenience of the trader. A trader can also initiate the Short Put Ladder strategy in the following way - Sell 1 ATM Put, Buy 1 OTM Put and Buy 1 Far OTM Put.

Strategy Sell 1 ITM Put, Buy 1 ATM Put and Buy 1 OTM Put
Market Outlook Significant movement (lower side)
Upper Breakeven Strike price of Short Put - Net Premium Received
Lower Breakeven Addition of two Long Put strikes - Strike Price of Short Put + Net Premium Received
Risk Limited (expiry between upper and lower breakeven).
Reward Limited to premium received if stock surges above higher breakeven Unlimited if stock falls below lower breakeven.
Margin required Yes

Let's try to understand with an example:

Nifty Current spot price (Rs) 9400
Sell 1 ITM Put of strike price (Rs) 9500
Premium received (Rs) 180
Buy 1 ATM Put of strike price (Rs) 9400
Premium paid (Rs) 105
Buy 1 OTM Put of strike price (Rs) 9300
Premium paid (Rs) 45
Upper breakeven 9470
Lower breakeven 9230
Lot Size 75
Net Premium Received (Rs) 30

Suppose Nifty is trading at 9400. An investor Mr. A is expecting a significant movement in the Nifty with a slightly more bearish view, so he enters a Short Put Ladder by selling 9500 Put strike price at Rs 180, buying 9400 strike price at Rs 105 and buying 9300 Put for Rs 45. The net premium received to initiate this trade is Rs 30. Maximum loss from the above example would be Rs 5250 (70*75). It would only occur when the underlying asset expires in the range of strikes bought. Maximum profit would be unlimited if it breaks lower breakeven point. However, profit would be limited up to Rs 2250(30*75) if it moves above the higher breakeven point.

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 Payoff from 1 ITM Put sold (9500) (Rs) Payoff from 1 ATM Puts Bought (9400) (Rs) Payoff from 1 OTM Put Bought (9300) (Rs) Net Payoff (Rs)
8700 -620 595 555 530
8800 -520 495 455 430
8900 -420 395 355 330
9000 -320 295 255 230
9100 -220 195 155 130
9200 -120 95 55 30
9230 -90 65 25 0
9300 -20 -5 -45 -70
9400 80 -105 -45 -70
9470 150 -105 -45 0
9500 180 -105 -45 30
9600 180 -105 -45 30
9700 180 -105 -45 30
9800 180 -105 -45 30

Impact of Options Greeks:

Delta: At the initiation of trade, Delta of the Short Put Ladder will be negative, indicating of a decent profit potential if the underlying asset moves lower.

Vega: Short Put Ladder has a positive Vega. Therefore, one should initiate Short Put Ladder spread when the volatility is low and expects it to rise.

Theta: A Short Put Ladder has negative Theta position and therefore it will lose value due to time decay as the expiration approaches.

Gamma: This strategy will have a long Gamma position, which indicates any significant downside movement, will lead to unlimited profit.

How to manage Risk?

A Short Put Ladder is exposed to limited loss; hence it is advisable to carry overnight positions.

Analysis of Short Put Ladder Strategy:

A Short Put Ladder is best to use when you are confident that an underlying security will move significantly lower. Another scenario wherein this strategy can give profit is when there is a surge in implied volatility. It is a limited risk and an unlimited reward strategy only if movement comes on the lower side or else reward would also be limited.

Short Call Ladder Options Strategy

A Short Call Ladder is the extension of Bear Call spread; the only difference is of an additional higher strike bought. The purpose of buying the additional strike is to get unlimited reward if the underlying asset moves up.

When to initiate a Short Call Ladder?

A Short Call Ladder spread should be initiated when you are expecting big movement in the underlying assets, favoring upside movement. Profit potential will be unlimited when the stock breaks highest strike price. Also, another opportunity is when the implied volatility of the underlying assets falls unexpectedly and you expect volatility to go up then you can apply Short Call Ladder strategy.

How to construct a Short Call Ladder

A Short Call Ladder can be created by selling 1 ITM call, buying 1 ATM call and buying 1 OTM call of the same underlying asset with the same expiry. Strike price can be customized as per the convenience of the trader. A trader can also initiate the Short Call Ladder strategy in the following way - Sell 1 ATM Call, Buy 1 OTM Call and Buy 1 Far OTM Call.

Strategy Sell 1 ITM Call, Buy 1 ATM Call and Buy 1 OTM Call
Market Outlook Significant moment (higher side)
Upper Breakeven Higher Long call strike price + Strike difference between short call and lower long call - Net premium received
Lower Breakeven Strike price of Short call + Net Premium Received
Risk Limited (expiry between upper and lower breakeven).
Reward Limited to premium received if stock falls below lower breakeven. Unlimited if stock surges above higher breakeven.
Margin required Yes

Let's try to understand with an example:

Nifty Current spot price (Rs) 9100
Sell 1 ITM call of strike price (Rs) 9000
Premium received (Rs) 180
Buy 1 ATM call of strike price (Rs) 9100
Premium paid (Rs) 105
Buy 1 OTM call of strike price (Rs) 9200
Premium paid (Rs) 45
Upper breakeven 9270
Lower breakeven 9030
Lot Size 75
Net Premium Received (Rs) 30

Suppose Nifty is trading at 9100. An investor Mr. A is expecting a significant movement in the Nifty with slightly more bullish view, so he enters a Short Call Ladder by selling 9000 call strike price at Rs 180, buying 9100 strike price at Rs 105 and buying 9200 call for Rs 45. The net premium received to initiate this trade is Rs 30. Maximum loss from the above example would be Rs 5250 (70*75). It would only occur when the underlying assets expires in the range of strikes bought. Maximum profit would be unlimited if it breaks higher breakeven point. However, profit would be limited up to Rs 2250(30*75) if it drops below the lower breakeven point.

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 Payoff from 1 ITM Call sold (9000) (Rs) Payoff from 1 ATM Calls Bought (9100) (Rs) Payoff from 1 OTM Call Bought (9200) (Rs) Net Payoff (Rs)
8600 180 -105 -45 30
8700 180 -105 -45 30
8800 180 -105 -45 30
8900 180 -105 -45 30
9000 180 -105 -45 30
9030 180 -105 -45 0
9100 80 -105 -45 70
9200 -20 -5 -45 -70
9270 -90 65 25 0
9300 -120 95 55 30
9400 -220 195 155 130
9500 -320 295 255 230
9600 -420 395 355 330
9700 -520 495 455 430
9800 -620 595 555 530

Impact of Options Greeks:

Delta: At the initiation of the trade, Delta of short call condor will be negative and it will turn positive when the underlying asset moves higher.

Vega: Short Call Ladder has a positive Vega. Therefore, one should initiate Short Call Ladder spread when the volatility is low and expects it to rise.

Theta: A Short Call Ladder has negative Theta position and therefore it will lose value due to time decay as the expiration approaches.

Gamma: This strategy will have a long Gamma position, which indicates any significant upside movement, will lead to unlimited profit.

How to manage Risk?

A Short Call Ladder is exposed to limited loss; hence it is advisable to carry overnight positions. However, one can keep stop Loss in order to restrict losses.

Analysis of Short Call Ladder Options strategy:

A Short Call Ladder spread is best to use when you are confident that an underlying security will move significantly. Another scenario wherein this strategy can give profit is when there is a surge in implied volatility. It is a limited risk and an unlimited reward strategy if movement comes on the higher side.

Long Iron Butterfly Options Strategy

A Long Iron 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 options at expiration. It is a limited risk and a limited reward strategy. A Long Iron Butterfly could also be considered as a combination of bull call spread and bear put spread.

When to initiate a Long Iron Butterfly

A Long Iron Butterfly spread is best to use when you expect the underlying assets to move sharply higher or lower but you are uncertain about direction. Also, when the implied volatility of the underlying assets falls unexpectedly and you expect volatility to shoot up, then you can apply Long Iron Butterfly strategy.

How to construct a Long Iron Butterfly?

A Long Iron Butterfly can be created by buying 1 ATM call, Selling 1 OTM call, buying 1 ATM put and selling 1 OTM put of the same underlying security with the same expiry. Strike price can be customized as per the convenience of the trader; however, the upper and lower strike must be equidistant from the middle strike.

Strategy Buy 1 ATM Call, Sell 1 OTM Call, Buy 1 ATM Put and Sell 1 OTM Put
Market Outlook Movement above the highest or lowest strike
Motive Profit from movement in either direction
Upper Breakeven Long Option (Middle) Strike price + Net Premium Paid
Lower Breakeven Long Option (Middle) Strike price - Net Premium Paid
Risk Limited to Net Premium Paid
Reward Higher strike-middle strike-net premium paid
Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price (Rs) 9200
Buy 1 ATM call of strike price (Rs) 9200
Premium paid (Rs) 70
Sell 1 OTM call of strike price (Rs) 9300
Premium received (Rs) 30
Buy 1 ATM put of strike price (Rs) 9200
Premium paid (Rs) 105
Sell 1 OTM put of strike price (Rs) 9100
Premium received (Rs) 65
Upper breakeven 9280
Lower breakeven 9120
Lot Size 75
Net Premium Paid (Rs) 80

Suppose Nifty is trading at 9200. An investor Mr A thinks that Nifty will move drastically in either direction, below lower strike or above higher strike by expiration. So he enters a Long Iron Butterfly by buying a 9200 call strike price at Rs 70 , selling 9300 call for Rs 30 and simultaneously buying 9200 put for Rs 105, selling 9100 put for Rs 65. The net premium paid to initiate this trade is Rs 80, which is also the maximum possible loss.

This strategy is initiated with a view of movement in the underlying security outside the wings of higher and lower strike price in Nifty. Maximum profit from the above example would be Rs 1500 (20*75). Maximum loss will also be limited up to Rs 6000 (80*75).

For the ease of understanding of the payoff, 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) 9200 Net Payoff from 1 OTM Call Sold (Rs) 9300 Net Payoff from 1 ATM Put bought (Rs) 9200 Net Payoff from 1 OTM Put sold (Rs.) 9100 Net Payoff (Rs)
8800 -70 30 295 -235 20
8900 -70 30 195 -135 20
9000 -70 30 95 -35 20
9100 -70 30 -5 65 20
9120 -70 30 -25 65 0
9200 -70 30 -105 65 -80
9280 10 30 -105 65 0
9300 30 30 -105 65 20
9400 130 -70 -105 65 20
9500 230 -170 -105 65 20
9600 330 -270 -105 65 20

Impact of Options Greeks before expiry:

Delta: The net Delta of a Long Iron Butterfly spread remains close to zero if underlying assets remain at middle strike. Delta will move towards 1 if underlying expires above higher strike price and Delta will move towards -1 if underlying expires below the lower strike price.

Vega: Long Iron Butterfly has a positive Vega. Therefore, one should buy Long Iron 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.

Gamma: This strategy will have a long Gamma position, so the change in underline assets will have a positive impact on the strategy.

How to manage Risk?

A Long Iron Butterfly is exposed to limited risk but risk involved is higher than the net reward from the strategy, one can keep stop loss to further limit the losses.

Analysis of Long Iron Butterfly strategy:

A Long Iron Butterfly spread is best to use when you are confident that an underlying security will move significantly. Another way by which this strategy can give profit is when there is an increase in implied volatility. However, this strategy should be used by advanced traders as the risk to reward ratio is high.

Short Call Condor Options Trading Strategy

A Short Call Condor is similar to Short Butterfly strategy. The only exception is that the difference of two middle strikes bought has different strikes.

When to initiate a Short call condor?

A Short Call Condor is implemented when the investor is expecting movement outside the range of the highest and lowest strike price of the underlying assets. Advance traders can also implement this strategy when the implied volatility of the underlying assets is low and you expect volatility to go up.

How to construct a Short Call Condor?

A Short Call Condor can be created by selling 1 lower ITM call, buying 1 lower middle ITM call, buying 1 higher middle OTM call and selling 1 higher OTM calls of the same underlying security with the same expiry. The ITM and OTM call strikes should be equidistant.

Strategy Sell 1 ITM Call, Buy 1 ITM Call, Buy 1 OTM Call and Sell 1 OTM Call
Market Outlook Significant volatility above higher and lower strikes
Motive Anticipating price movement in the underlying assets
Upper Breakeven Highest strike price - Net credit
Lower Breakeven Lowest strike price + Net credit
Risk Limited (if expires above lower breakeven point and vice versa)
Reward Limited to Net premium received
Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price 9100
Sell 1 ITM call of strike price (Rs) 8900
Premium received (Rs) 240
Buy 1 ITM call of strike price (Rs) 9000
Premium paid (Rs) 150
Buy 1 OTM call of strike price (Rs) 9200
Premium paid (Rs) 40
Sell 1 OTM call of strike price (Rs) 9300
Premium received (Rs) 10
Upper breakeven 9240
Lower breakeven 8960
Lot Size 75
Net premium received 60

Suppose Nifty is trading at 9100. An investor Mr. A estimates that Nifty will move significantly by expiration, so he enters a Short Call Condor and sells 8900 call strike price at Rs 240, buys 9000 strike price of Rs 150, buys 9200 strike price for Rs 40 and sells 9300 call for Rs 10. The net premium received to initiate this trade is Rs 60, which is also the maximum possible reward. This strategy is initiated with a view of significant volatility on Nifty hence it will give the maximum profit only when there is movement in the underlying security below 8900 or above 9200. Maximum profit from the above example would be Rs 4500 (60*75). The maximum profit would only occur when underlying assets expires outside the range of upper and lower breakevens. Maximum loss would also be limited to Rs 3000 (40*75), if it stays in the range of higher and lower breakeven.

For the ease of understanding of the payoff schedule, we did not take in to account commission charges. Following is the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY closes at Net Payoff from 1 Deep ITM Call Sold (Rs) 8900 Net Payoff from 1 ITM Calls Bought (Rs) 9000 Net Payoff from 1 OTM Call bought (Rs) 9200 Net Payoff from 1 deep OTM Call sold (Rs.) 9300 Net Payoff (Rs)
8600 240 -150 -40 10 60
8700 240 -150 -40 10 60
8800 240 -150 -40 10 60
8900 240 -150 -40 10 60
8960 180 -150 -40 10 0
9000 140 -150 -40 10 -40
9100 40 -50 -40 10 -40
9200 -60 -50 -40 10 -40
9240 -100 90 0 10 0
9300 -160 150 60 10 60
9400 -260 250 160 -90 60
9500 -360 350 260 -190 60
9600 -460 450 360 -290 60

The Payoff Graph:

Impact of Options Greeks before expiry:

Delta: If the underlying asset remains between the lowest and highest strike price the net Delta of a Short Call Condor spread remains close to zero.

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

Theta: Theta will have a negative impact on the strategy, because option premium will erode as the expiration dates draws nearer.

Gamma: The Gamma of a Short Call Condor strategy goes to lowest if it moves above the highest or below the lowest strike.

Analysis of Short Call Condor spread strategy

A Short Call Condor spread is best to use when you are confident that an underlying security will move outside the range of lowest and highest strikes. Unlike straddle and strangles strategies risk involved in short call condor is limited.

Short Call Butterfly Option Trading Strategy

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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