Time value has always been a big pain for option traders who wish to trade them for benefiting from a directional move. By the virtue of the risk assignment to the buyer and the seller of the option, one more or less needs to be net buyer or net neutral of the options position to have a risk profile which entails lower risk than expected gains out of a directional trade.
So, for anyone who wants to be directional trader, there is definitely a cost assigned. On the positive side with options trade, considering the directional outlook and net long or neutral option there would be no risk of loss due to the directional adversities.
The cost of option, in other words the cost of privilege to benefit from the positive directional move and not lose from the negative directional move is the premium. Considering the at the money (around the underlying price), the premium would constitute only time value.
Now, when the market tones down the momentum, this time value becomes a killer. The loss led by time value decay in many cases may over shadow the profit from direction. So, in such cases, where the time can Kill the Trade, we will proactively resort to OTM Butterfly and Kill the Time in Trade with OTM Butterfly.
Let us understand what Butterfly strategy is first. A Butterfly strategy is where we sell 2 Calls or 2 Puts depending upon the upward or downward move expectation and Buy a Lower strike Call/Put and a higher strike Call/Put at equal distance. The Maximum profit would be with expiry at the center strike. Maximum profit would be the difference between Buy & Sell strikes minus the premium paid at the time of initiation.
This is perfect for a consolidating market, however there is still a possibility of the upper or lower bound being taken out in the upcoming gyration. If that happens the Butterfly strategy would still yield a loss beyond the bought strikes.
Now let us understand the OTM part of it. OTM is nothing but when the center strike of which 2 options are sold is chosen to be OTM. OTM means higher Call or Lower Put. Try to choose this strike which is closest to the targeted value.
For example, if a stock is trading at 100 after its recent runup from 70. We are looking at very slow move to 107. The OTM Butterfly is ideal strategy. Considering strikes are placed at 2.5 apart, we can resort to following strategy. (Its Bullish outlook hence Call OTM Butterfly)
Sell 2 Lots 107.5 Calls
Buy 1 Lot 105 Call
Buy 1 Lot 110 Call
Since it is a distant set of strikes, the cost would be minuscule. Expiry profitability could range into 8-10:1 Reward: Risk in some cases.
Now, as the days pass. 1 out of 3 scenarios can emerge. Let us understand what they are and how are we expected to react to it.
1. Expiry is approaching and the price is approaching 107.5: In this ideal scenario, a lot of people would wait till the end for those terminal time values to be decayed. But my practice has been, if there is a profit any more than 3X the premium paid, I would take that and leave.
2. Stock runs up to 107.5 in a day or two: The faster move will adversely affect this trade because the profitability emerges only after the passage of time. Nonetheless, empirical evidence has it that even in such cases there is at least 1.2-1.5X profit on the table.
Either take it and leave or move the trade to another OTM butter fly with the updated forecast after the move.
3. Stock remains at 100 or reverses: In this case ideally you would adhere to a stop loss strategy but since the net debit (premium paid), which is the maximum loss, is so low, we may just let it run till the target becomes a very remote possibility.
I know of traders on our bourses who have been just using Butterflies to trade. Over a period, they have become such good craftsmen of this trade that they do not have to resort to any other strategy. You may not do that, but if there is a lot of time to kill in a directional trade, Kill it with OTM Butterfly.
(The author is CEO & Head of Research at Quantsapp)Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.