Last week, we discussed about modified butterfly, a strategy where the distance between the higher strike and the middle strike is less than the distance between the middle strike and the lower strike. What if you implement a mod butterfly strategy where the distance between the middle strike and the lower strike is less than the distance between the higher strike and the middle strike? This week, we discuss when such a strategy could be attractive.
The maximum gain in a mod butterfly is the same as in the case of a normal butterfly. This means the difference between the middle strike and the lower strike is important, as it determines the maximum gains on a mod butterfly. If the distance between the middle strike and the lower strike were to be less than the distance between the higher strike and the middle strike, will the strategy be unattractive?
Consider a strategy where you are long one contract of next-week 19900 call, short two contracts of 20000 call and long one contract of 20100 call on the Nifty Index. The position can be set up for a net debit of 15 points. Therefore, the maximum gain is 85 points. But what if you were to modify this strategy such that you are long one contract of 19900 call, short two contracts of 19950 call and long 20100 call? You can set up the position for a net credit of 39 points, as the short middle strike is closer to the long lower strike. The maximum gain will be 89 points, which is the difference between the strikes (19950 less 19900) plus net credit. Therefore, the maximum gain is higher than that of the normal butterfly.
But what will happen if the underlying trades above 20100 at expiry of the options? The position could lose about 60 points. In fact, if the underlying were to trade at a price equal to the higher strike or any price above, the strategy will lose 60 points. This is because the strategy has a naked short position in the 19950 call, which will gather losses if the underlying trades between 19950 (middle strike) and 20100 (higher strike). Note that one short 19950 call is covered by the long 19900 call. The greater the distance between the higher strike and the middle strike compared with the middle strike and the lower strike, the greater the potential losses on this strategy.
The mod butterfly strategy discussed above would be optimal when you expect the underlying to hardly move or at best move marginally upwards. The strategy offers gains from intrinsic value on the lower strike call and gains from time decay on the two short middle strike calls. If you were to set up a mod butterfly strategy, it is preferable to create one where the distance is smaller between the higher strike and the middle strike, the strategy that we discussed last week.
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