When in doubt to write, do Iron Fly: Shubham Agarwal

F&O Cues

It is not unusual to find a situation when the underlying trend is indecisive. Let us define the impact of indecisive (Doubt) to figure out what is the problem with Writing (Option Selling) in doubt is a problem. Then we will understand how Iron Fly turns out to be the prefect solution.

Sell Puts if the undertone is Bullish, sell Calls in a Bearish market but Option Writers (Sellers) have to deal with more than direction. Option writers also trade volatility. When one is in doubt the one thing that becomes unpredictable is volatility.

To survive in a very wrong trade while writing options in such a market where there is doubt, one needs protection from all ends at the same time reward that is encouraging enough to trade. Solution is Iron Fly

In Iron Fly we sell the option that holds the highest value that is expected to go down with time.

1.       Sell Call (Strike = Closest to Current Market Price)

2.       Sell Put (Strike = 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 clearly.

Underlying Trading at 200.2

Sell 200 Call @ 2.5

Sell 200 Put @ 2.5

Buy 205 Call @ 1 (200 +2.5 + 2.5)

Buy 195 Put @ 1 (200 – 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 @ 200)

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

Our Example Max Loss = 5 – 3 = 2 (With Expiry above 205 or below 195).

When we trade, no one holds the position till the day of expiry. Instead, we keep a stop loss at the bought strike levels both up and down. If the stock were to trade above 205 or below 195, exit the trade and trigger the stop loss.

At that time the loss would be much less than 2. For profits too, for weekly expiry of Indices we can build and hold the strategy till at least 60% of profits are realized. Even if we are getting more than 2 out of the trade we could exit.