Shubham Agarwal
Nifty has been making rounds into a 2% range since the beginning of August 2024. This does not help the directional traders. However, we have all created a firm grip on Option writing.
Writing Options during such a tight range bound market could be profitable yet highly risky. This is because the breakouts could take away more than what we have earned during the range writing trades.
In such situations one strategy that really helps is Iron Butterfly. We will see the definition of this strategy along with how to construct, how to initiate and when to exit.
Iron Butterfly is a strategy designed to trade range-bound or consolidation outlook but with a perfect layer of protection.
The strategy has 4 trades:
1. Sell Call (Strike = Closest to Current Market Price)
2. Sell Put (Strike = Closest to Current Market Price same as Call)
3. Buy Call (Strike = Higher than Current Market Price, Call Hedge)
4. Buy Put (Strike = Lower than Current Market Price, Put Hedge)
1 & 2: Strikes closest to current market will always have maximum premium available for us to gain if the underlying does not move.
3 & 4: Higher Strike Call and Lower Strike Put are bought as Hedge to safeguard against Sold Call and Sold Put. If the underlying gives a big move in any direction we are protected with a Buy option against a Sell Option.
Strike selection can be simple. We add the premium collected by Selling Call and Put. Add it to the Sold Strike to arrive at the Higher Call Strike and subtract from the Sold strike to arrive at the Lower Put Strike.
Following example will explain this clearer:
Underlying Trading at 1005
Sell 100 Call @ 2.5
Sell 100 Put @ 2.5
Buy 105 Call @ 1 (100 +2.5 + 2.5)
Buy 95 Put @ 1 (100 - 2.5 - 2.5)
This is a known and limited loss strategy.
Max Profit = Net Premium Received
Example, Max Profit = 2.5 + 2.5 – 1 – 1 = 3 (With Expiry @ 100)
Maximum Loss = Difference between Sold and Bought Strikes - Maximum Profit
Our Example Max Loss = 5 – 3 = 2 (With Expiry above 105 or below 95)
Early Exit?
It is not compulsory nor required to exit during the expiry but if Nifty crosses any of the Buy strike and if you feel the trend may continue one may exit. In such case, the Loss would be lower than the Maximum Loss we calculated.
Example: If the underlying crosses 105 and if I feel it may go up to 110 by expiry, I will rather exit during the expiry at a loss lower than maximum loss.
As far as execution goes, we need to be mindful of one thing. This is a strategy that needs to be done systematically for every expiry of the consolidation. Consistency in execution and discipline in entry and exit is essential for the Iron Butterfly to work.
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