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A recent discussion we had with traders focused on low volatility strategies. In this regard, a short straddle or a short strangle often comes to one’s mind. But not many traders are comfortable shorting options to bet on volatility implosion (decrease in volatility). That is why long butterfly strategy becomes relevant. This week, we discuss on how to decide between long put butterfly and long call butterfly.
Call or put?
A butterfly strategy has two unique characteristics. One, the three strikes (legs) are equidistant from each other. And two, the strategy involves going long on the outer strikes and short on the inner strike in the ratio of 1:2:1. Interestingly, the butterfly can be set up for a net credit if the premium on the short leg is significant.
As with any trade that involves a short leg, the maximum profit on a butterfly occurs when the lower strike expands to its maximum intrinsic value subject to the condition that the short strike expires worthless. Therefore, the butterfly generates maximum gains when the underlying asset is at the middle strike (the short strike) at expiry. Note that the distant between the strikes are unlikely to be large. This aligns with the objective of the strategy — it is set up to take advantage of a view that the underlying will move slowly, and that the underlying’s price change will be small.
The strategy can be set up either using all calls or all puts (but not a combination of the two). But how should you decide between a call and a put butterfly? Consider a call butterfly. With the Nifty Index at 19393, suppose you set up the strategy with one long 19300 call, two short 19400 calls and one long 19500 call. The strategy can be set up for a net debit of 14 points. The maximum gains on the strategy will be 86 points, which is 100 (difference between the strikes) less the net debit. Suppose you consider a put butterfly with one long 19500 strike, two short 19400 strikes and one long 19300 strike. This position can be set up for a net debit of 15 points. The maximum gain on this position is 85 points using the same logic as above.
The above discussion indicates that with both call and put butterfly strategies, the maximum gain occurs when the underlying is at the middle strike, which is the same strike for both strategies. Therefore, the decision between a call and put butterfly is simple. You must choose the one which has lower net debit or higher net credit.
Optional reading
The position benefits from volatility implosion. Therefore, gains come from loss in time value from the middle strike in addition to increase in delta from the lower strike (call butterfly) or from the higher strike (put butterfly). The position will not generate gains if the underlying trades above the higher strike for call butterfly or the lower strike for put butterfly.
The author offers training programmes for individuals to manage their personal investments
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