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Iron Butterfly-Neutral Strategy

Options-Trading-Beginners

Explanation

Iron butterfly option strategy is initiated by an operator when he expects underlying to stay in range with low volatility from the underlying. The strategy is implemented for a credit. The width of the winds in butterfly spread or in other word the spread from the short strike defines the maximum risk for the strategy.

The options trading strategy combines multiple calls and put options. Implementation involves selling at-the-money call and put options or shorting straddle and simultaneously buying OTM option for hedging positions.

The combined credit of the spreads defines the maximum profit for the trade and the maximum risk is defined by the spread width minus the credit received.

Risk:

Max. risk is limited to the spread width minus the premium received

Reward:

Maximum reward is the net premium received from shorting ATM call and put options

Construction

Buy 1 OTM Call Option

Sell 1 ATM Call Option

Sell1 ATM Put Option

Buy1 OTM Put Option

Option Type Expiry Date Strike Price LTP Action No. Of Lots
CALL 25-05-2023 43800 268 Buy 1
PUT 25-05-2023 43600 372.35 Buy 1
CALL 25-05-2023 43700 313.6 Sell 1
PUT 25-05-2023 43700 422.7 Sell 1

 

Market Expiry Payoff 1 Payoff 2 Payoff 3 Payoff 4 Net Premium Option PayOff At Expiry
42900.0 0.0 700.0 0.0 -800.0 95.95 -4.05
43000.0 0.0 600.0 0.0 -700.0 95.95 -4.05
43100.0 0.0 500.0 0.0 -600.0 95.95 -4.05
43200.0 0.0 400.0 0.0 -500.0 95.95 -4.05
43300.0 0.0 300.0 0.0 -400.0 95.95 -4.05
43400.0 0.0 200.0 0.0 -300.0 95.95 -4.05
43500.0 0.0 100.0 0.0 -200.0 95.95 -4.05
43600.0 0.0 0.0 0.0 -100.0 95.95 -4.05
43700.0 0.0 0.0 0.0 0.0 95.95 95.95
43800.0 0.0 0.0 -100.0 0.0 95.95 -4.05
43900.0 100.0 0.0 -200.0 0.0 95.95 -4.05
44000.0 200.0 0.0 -300.0 0.0 95.95 -4.05
44100.0 300.0 0.0 -400.0 0.0 95.95 -4.05
44200.0 400.0 0.0 -500.0 0.0 95.95 -4.05
44300.0 500.0 0.0 -600.0 0.0 95.95 -4.05
44400.0 600.0 0.0 -700.0 0.0 95.95 -4.05
44500.0 700.0 0.0 -800.0 0.0 95.95 -4.05

 

Payoff Chart

 

Example

 Bank nifty is trading at 43800 levels and trader is very bearish on volatility and neutral on index. He executed iron butterfly strategy where he bought and shorted call and put options. The strategy involved buying 1 43600 put option at premium of Rs 372, selling 1 43700 put option at premium of Rs 422, selling 1 43700 call option at premium of Rs 314 and buying Rs 43800 call option at a premium of Rs. 268. Total inflow at beginning comes at Rs 2400 (314+422 – 268 – 372) * 25.

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    Scenario 1:

    If the price of the underlying closes on extreme level of either side i.e., 42900 or 44500, the resulting trade will end up making loss to trader. The short position on wither side ill make bigger loss that the gains from the long position a shown in the table above.

    Scenario 2:

    The trader will make profit if the price of the underlying closed close to the short call and put option. Under such scenario, both short options will expire worthless and the trader will be able to keep the premium received.

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