Derivatives are designed to take advantage of changing stock market volatility and patterns. Several futures and options strategies are present in today’s environment that allows stock market traders not only to hedge their positions but also make profit by cutting the cost and risk. Let’s discuss two such options strategies that are used actively in the financial markets to take advantage of sideways market action. Structurally the way of execution for both the strategies remains almost similar to each other it’s just the use of either a call option or a put option that makes the basic difference in these strategies. We work out with the factors and mathematics that work for both the strategies before we take an illustration for each of them.
How does long call butterfly & long put butterfly helps traders in buying & selling stocks
- In long butterfly strategies one is directionally neutral and bets on low volatile range bound scenarios, therefore it is best to avoid these strategies ahead of earnings results or big announcement, while it makes sense to trade them after high volatile action when the stock tends to consolidate after big moves.
- Stock market trader must closely watch major areas of support and resistance before indulging the position.
- Executing long butterfly options closer to expiry say around a month or so are recommended as the strategy involves selling the options also therefore the time decay works your way.
- At the time of exiting the position all the legs need to be squared up, while at an advanced stage trader may unfold part position as per the setup near the expiry.
Also Read : Options Strategy: Straddle and Strangle
The long call butterfly involves selling two call options near the current price, while simultaneously buying two call options of different strike prices, the first one below the current price i.e. “in the money“ call option and the other one above the current price i.e. “out of the money” call option. All the options have to be of same expiration and only call options are used. An important thing to consider here is that the entire options price must be equidistant from the adjacent strike price. The maximum risk here remains limited to the extent of net premium outflow paid up front, the maximum gains at the same time also remain limited but in an ideal scenario they tend to be spectacular. Below is a hypothetical example:
The stock is trading at 100
Sell 2 lots call option 100 strike price @ 11.50 each
Buy 1 lot call option 90 strike price @ 20
Buy 1 lot call option 110 strike price @ 6
Below is another example of long put butterfly. The long put butterfly is also a range bound strategy, just similar to the long call butterfly except for one thing that it requires the use of put option instead on call option. To make the strategy one needs to sell two near strike price put options while buy one in the money and one out of the money put option that are equidistant from the sold put option. The long butterfly strategies are popular given the little cost incurred in their application while lucrative profit potential they possess. Maximum return is generated when the stock remains closer to the middle strike price at expiration.
The stock is trading at 100
Sell 2 lots put option 100 strike price @ 9 each
Buy 1 lot put option 110 strike price @ 15.50
Buy 1 lot put option 90 strike price @ 5
The long butterfly might look simpler initially but to execute a profitable strategy one needs to have a good understanding of the factors & cost involved but once you master them it is going to be a cool breeze blowing your way!