Markets spend most of their time in ranges and only a fraction of time trending. In trending markets, traders are happy because they get clear directional movement. But in range bound markets, traders get frustrated. They don't get the expected move and get trapped repeatedly on either side.
When markets remain range bound for several days, they become even more erratic on smaller timeframes. One day it goes up showing all positive signals and data. The next day it completely reverses direction and gives a deep down move. In such scenarios, directional trading becomes inconsistent. So the bigger question is: How do we benefit from range bound markets? The solution is simple. Deploy strategies that profit when the market stays within a range. Let us understand one such strategy.
The strategy we will look at today is Iron Butterfly. Think of it as protected option selling.
Here is how it works. Sell both Call and Put at strikes closest to the market price with the nearest expiry. Then buy a higher strike Call and lower strike Put with the same expiry. This buying protects us from unlimited loss.
The strikes we choose for buying depend on various factors. The easiest choice if you do not have other analytics is to pick the highest Open Interest Call strike and highest Open Interest Put strike. Try to keep the distance between Sell and Buy strikes the same on both sides.
Let us take an example. Suppose Nifty is trading near 25000 on Friday afternoon. Weekly expiry is on Tuesday.
We sell 25000 Call at 128 and 25000 Put at 138. We buy 25250 Call at 35 and 24750 Put at 38.
Our maximum profit equals the net premium we receive. That is 128 plus 138 minus 35 minus 38, which equals 193 points.
Our maximum loss equals the difference between buy and sell strikes minus the net premium. That is 250 minus 193, which equals 57 points.
The profit zone is the range where the strategy makes money at expiry. Add the net premium to the call sell strike to get the upper limit. Subtract the net premium from the put sell strike to get the lower limit. In our example, that gives us 25193 and 24807. If Nifty stays between these two levels at expiry, both the options you sold lose value and the strategy makes profit.
Notice we are using weekly expiry and entering in the second half of the week. This allows us to capture the range bound behavior in a shorter timeframe.
One important point to remember. Always check if you are comfortable with the payoff before entering the trade. If the maximum loss seems too large for your risk appetite, you can choose strikes closer than 250 points. This will reduce your profit but also reduce your risk. The key is to find a balance that suits your trading style.
There are other strategies to benefit from range bound markets. But that we will discuss some other day.
Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decision.
Discover the latest Business News, Sensex, and Nifty updates. Obtain Personal Finance insights, tax queries, and expert opinions on Moneycontrol or download the Moneycontrol App to stay updated!
