Nifty stuck, Iron Fly to the rescue: Shubham Agarwal

December is a month of low volatility. Seasonally low action and a tug-o-war between some of the major sectors have resulted in the major index Nifty to be bound in a tight range. This may be bad news to a lot of directional traders but it is good news to option writers.

However, times like these do present a set of challenges for the option writers too. The price of options in times like these are relatively low. The risk index, India VIX, trades at a lower level during consolidation. This puts a pressure on option premiums. So, selling higher Calls and Lower Puts with high probability of ending up worthless is not profitable for the investment made.

To take care of this we sell the option that holds the highest value that is expected to go down with time. The strategy to do this with limited and known loss is via Iron Fly.

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 the current market will always have the 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.

The following example will explain this clearer.

Underlying Trading at 1005

Sell 1000 Call @ 25

Sell 1000 Put @ 25

Buy 1050 Call @ 10 (1000 +25 + 25)

Buy 950 Put @ 10 (1000 - 25 - 25)

This is a known and limited loss strategy.

Max Profit = Net Premium Received

Example, Max Profit = 25 + 25 – 10 – 10 = 30 (With Expiry @ 1000)

Maximum Loss = Difference between Sold and Bought Strikes - Maximum Profit

Our Example Max Loss = 50 – 30 = 20 (With Expiry above 1050 or below 950).

In practice, no one holds the position till the day of expiry. So keep a stop loss at the bought strike levels. If the stock were to trade above 1050 or below 950, exit the trade.

At that time the loss will be much less than 20. For profits too, for weekly expiry of Nifty we can build and hold the strategy till at least 60% of profits are realized. Even if we are getting even 18-20 out of the trade we are good to exit.

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 decisions.