Understand the concept of butterfly spread and how the market react to it
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Learn about Weekly Butterfly Spreads
If you have been following the market over the past few months, you will have noticed a tremendous amount of volatility in the work. From a euphoric post pandemic environment to sharp plunges nearing bear territory, both global and Indian equities have indicated significant fluctuations, putting traders in a fix. Factors such as the rising inflation, geopolitical risk and tightening of interest rates have been attributed to the negative sentiment which has caused massive notional and real losses to investors. In this scenario, traders are wondering if there is a way to benefit from the volatility and still earn returns in a plunging market. The answer is, yes, there is a way and it involves the use of the weekly butterfly.
Weekly Butterfly Spreads
Butterfly spread indicates an options trading strategy which combines bull and bear spreads to navigate the volatility. The weekly butterfly allows you to trade and earn returns while undertaking only a fixed amount of risk. However, since your risks are mitigated, your profits will also be capped if you use this strategy. Therefore, this strategy is especially beneficial in a volatile market as you can still earn some profits without risking your wealth. Weekly butterfly spreads can be considered a market-neutral strategy and aims to offer you the maximum returns in the scenario where the underlying security does not move in line with speculation before the expiry of the option.
Usually, butterfly spreads involve either four call options, four put options or a combination of these options with three different strike prices. Traders invest in upper and lower strike prices which are placed at equal distance from the middle, or at-the-money strike price to mitigate risk and enhance profit margins. This means that, if the at-the-money options have a strike price of Rs 50, then the upper and lower options should have an equal difference from Rs. 50. This could be anything from Rs. 20 and Rs. 80 to Rs. 45 and Rs. 55, based on the market scenario.
Weekly Butterfly Strategy
You can use the different butterfly strategies to earn weekly incomes. Different combinations of options will help you create different types of weekly butterfly spreads and, using these, you can earn profit in both volatile and stable market situations. Mostly used in a non-directional market, traders can opt for long or short positions on options or combine the two, based on their speculation and payoff strategy. For instance, if you believe that the stocks of HDFC could see some bullishness ahead of the proposed merger with HDFC Bank, you can enter a long butterfly bull spread option by purchasing one lot each of next month expiry call options at the strike prices which are at equal distances above and below the at-the-money price. Then you can sell lots of call options at strike price and the maximum loss you will face, when the options expire, will be limited to the differential between the options. The payout at the expiry of the butterfly spread will involve the price difference between the strike price and the put or call options, helping you earn returns even during volatile markets. You can also opt out of the strategy before expiry and still earn a fixed amount of returns in line with the options you purchased and sold previously.
Please note that, while using weekly butterfly strategies, you will earn the maximum profit when the cash price is equivalent to the middle strike price. Alternatively, if the cash price ends up between the high and low strike prices chosen by you, you will still earn a profit but this could be impacted by the applicable trading costs and taxes. Therefore, be careful to ensure that your butterfly spread strategy does not cause you a loss due to high trading charges or taxes.
Underlying Risks
If you are not well-versed with the options market, or take the wrong call, you may end up facing losses. A big concern for traders involves the fact that options may have a long expiry period. This means that market sentiments may change drastically after you place your bets, causing you potential losses. Weekly butterfly can help you stick to a weekly practice and avoid long calls. The strategy may also end up being reversed by aspects such as the shorting option as it is almost impossible to time the market perfectly all the time. Further, the higher trading costs, commissions and taxes involved in weekly butterfly spreads could also eat into the profits you earn so ensure that you keep all these points in mind before trying your hand at this strategy.
It is true that volatility can also offer tremendous possibilities for earning profits but you must be aware of all the nitty gritty of the weekly butterfly before you use your hard-earned money at speculation. As is often said, it is better to be safe than sorry so build your positions only after lengthy and extensive research to ensure the best possible outcomes.
Frequently Asked Questions
What is a Butterfly Spread in trading?
A Butterfly Spread is an advanced options trading strategy that involves combining multiple options to limit both potential profit and loss. It is often used when a trader expects minimal price movement in the underlying asset.
How does a Butterfly Spread work?
A Butterfly Spread typically consists of buying one lower strike option, selling two at-the-money options, and buying one higher strike option, all with the same expiry. This creates a “butterfly-shaped” profit-loss diagram.
What are the types of Butterfly Spreads?
The main types are Call Butterfly Spreads, Put Butterfly Spreads, and Iron Butterfly Spreads. Each has unique setups and uses based on the trader’s outlook and risk tolerance.
When should I use a Butterfly Spread?
A Butterfly Spread is ideal when you anticipate minimal volatility in the underlying asset and expect the price to stay near the strike price of the sold options.
What are the benefits of using a Butterfly Spread?
Butterfly Spreads offer limited risk, require low initial capital, and provide a defined profit potential. They are suitable for traders aiming for steady returns in a low-volatility market.
What are the risks associated with Butterfly Spreads?
The primary risk is that the underlying asset’s price moves significantly away from the central strike price, reducing the chances of making a profit.
How is an Iron Butterfly different from a standard Butterfly Spread?
An Iron Butterfly involves using both calls and puts, combining a short straddle with long options at a higher and lower strike price. This contrasts with standard Butterfly Spreads, which use either calls or puts exclusively.
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