Options trading is a form of derivatives trading that involves buying and selling contracts for an underlying asset such as stocks, commodities, or currencies. With options, you can pay a premium to obtain the right to buy or sell an underlying asset on a particular date.
However, there is no obligation to execute the contract. If you are new to it, you will be glad to know that there are hundreds of option trading strategies to help you get started.
These strategies vary according to the requirement, but most of them aim to reduce the risk and increase the profit. The butterfly options strategy is one such options trading strategy. The question is how to use it. Read on to know more.
What is the Butterfly Option Strategy?
The Butterfly Strategy is known as a neutral options strategy that combines bull and bear spreads together across a four-legged strategy.
That means the trader will trade four different options contracts at three different strike prices in a 1:2:1 ratio. Whatever’s 1 from the ratio is known as the wings while the put or call option represented as 2 is known as the body.
But guess what? All contracts will have the same expiry date. This strategy is usually implemented in the second half of the last few days of the options contract’s expiry to benefit from the time value of the options premium.
A trader who has a bullish view of the market will look to buy or follow a “call butterfly” strategy whereas a trader who has a bearish view will opt to sell or follow a “put butterfly” strategy.
Either way, the key behind the Butterfly strategy is to forecast the price up until expiry and profit from the time value of the options premium, all the while undertaking limited risk.
A long call butterfly can be initiated by:
- Buying 1 In the Money (ITM) call (wing)
- Selling 2 At the Money (ATM) calls (body)
- Buying 1 Out of the Money (OTM) call (wing)
These three calls create the body (selling options) and wings (buying options) of the butterfly in the chart, which gives this popular option trading strategy its name. Let us understand the concept with a Butterfly Strategy example.
Mr. Amitabh invests in Reliance Industries Limited (RIL) shares at Rs 180 per share. He expects the stock price to fall, and thus opts for a long call butterfly spread.
Thus, he buys 2 call options at a strike price of Rs 180 and sells 2 call options at Rs 170 and 190. In this way, his profit or loss becomes limited even if the price rises or falls more than the maximum limit.
|Buy 1 RIL||Rs 170||Rs 5 (Premium paid)||Wing|
|Sell 2 RIL||Rs 180||Rs 6 (Premium received)||Body|
|Buy 1 RIL||Rs 190||Rs 2 (Premium paid)||Wing|
The total cost or expense in this butterfly is Rs 1 (Rs 6 – Rs 5 – Rs 2= Rs -1). Thus, if the stock price dips from Rs 170, Mr. Amitabh incurs a total loss of Re 1.
However, if the stock price increases, he enjoys a profit of Rs 9 (Rs 180 – Rs 170 -Re 1 (net cost incurred)). He was thus able to cap both his loss and profit using the butterfly option strategy.
Types of Butterfly Trading Strategies
Calls and puts options are used for creating a butterfly spread. When we combine options in various ways, it creates different butterfly spreads. Each spread is constructed to gain from an increase or decrease in volatility.
For call options, there are two types of butterfly strategies:
- Long Call Butterfly: Buy a single in-the-money call (low strike price), sell two at-the-money calls, and buy one out-of-the-money call (high strike price)
- Short Call Butterfly: Selling a single in-the-money call (low strike price), buy two at-the-money calls, and sell a single out-of-the-money call (high strike price)
While for put options, there are also two types of butterfly strategies:
- Long Put Butterfly: Buy a single put option (low strike price), sell two at the money puts, and buy a single put (high strike price)
- Short Put Butterfly: Sell a single out of the money put (low strike price), buy two at the money puts, and sell a single in the money put (high strike price)
There are also butterfly strategies that combine buying or selling call-and-put options. These are the iron butterfly and reverse iron butterfly strategies.
Things to Remember When Using Butterfly Option Strategy
A trader must remember that all the options contracts executed in the strategy belong to the same underlying asset. For example, you cannot implement this strategy on an option contract for both stocks and currencies at the same time.
You need to ensure that the call options belong to the same expiry and that the strike prices are equidistant for all calls. For example, the difference between ITM, OTM, and ATM should be of the same amount.
Where to Implement Butterfly Option Strategy?
Before getting on with options trading using strategies, remember that the stock market is a highly dynamic place. Make sure to educate yourself on every aspect of the strategy and pre-plan the trade for the best results.
Some web trading platforms offer the ability to execute option strategies. However, if you want an easier way of using an options strategy, you can take a look at Dhan’s options trading app.
The app contains various pre-built options trading strategies that can be executed in a few simple steps.
If you want a newer way of trading derivatives, option trading strategies can come in handy. The butterfly options strategy aims to gain on the time value of money. It reduces the risk and enhances the chances of profit.
When compared to the normal spreads such as bull and bearish options strategies, the Butterfly strategy involves lower sensitivity in price movements. Thus, the Butterfly strategy allows the scope of better profit and lower risk, as it can hedge against major intraday volatility and wide price movements.
If you need a starting point, you can choose to trade options on the Dhan Options Trading App, which comes with pre-built options trading strategies.
Make sure you consider all factors such as price movements, contract expiry date & overall market outlook before getting started with the butterfly trading strategy.