Curtail risk with Modified Call Butterfly to trade longs confidently after rise, says Shubham Agarwal



Shubham Agarwal

We have seen a spectacular rally in the last few months. The pullbacks have been less fierce after each up move. It is not unusual after such a rise to miss a few aggressive moves (eg creating longs after a strong rally). Previous moves have, however, shown that the stocks and indices have a lot to offer.

So, why don’t we reshape our trades, especially the ones that are missed due to recent performance already in place. At least for those bets, instead of missing the move entirely, we could trade using a Modified Call Butterfly.

Let us understand the strategy to optimally utilise it. Two factors that we need to account for are profit potential and loss-limiting capabilities. Let us examine both these issues and figure out how modified butterfly turns out to be a cheaper alternative to this peculiar situation.

Now, consider a situation where the indices have reached up to recent highs, giving us an indication that there could be a pause and a range that the indices might get stuck into. In such a situation the next round of upward gyration is expected to be played with.

For this, a butterfly strategy is apt and most inexpensive, especially with the weekly expiries now available for trading, deploy a butterfly strategy with the centre strike at the expected and empirically proven upper bound or lower bound.

A butterfly strategy is where we sell two Calls/ two  Puts, depending on the upward or downward move expectation and buy a lower strike Call/Put and a higher strike Call/Put at equal distance. The maximum profit would be with expiry at the centre strike. Maximum profit would be the difference between buy and sell strikes minus the premium paid at the time of initiation.

This is perfect for a slow-moving market, however, we now have to account for a possibility of the upper bound being taken out in the upcoming gyration. If that happens, the butterfly strategy would still yield a loss beyond the bought strikes.

While the butterfly is capable of ticking off the first issue of limited loss capabilities, we still need to modify it to take care of keeping the pay-off positive in case of a huge break-out.

Let us take the example of the Bank Nifty Band to try to seek a solution out of this. Assume that the Bank Nifty is at 32,000. Now to trade a move towards the upper band at 33,000, one would resort to a butterfly with the following trades

Buy 1 Lot 32300 CE @ 190

Sell 2 Lots 33000 CE @ 55

Buy 1 Lot 33700 CE @ 15

Maximum Profit = 700 (Difference between strikes) – 95 (190 – 110(55 *2) + 15) = 605

Maximum Loss = 95

This is how it will outperform another directional strategy on the risk front but the trade will become unprofitable if there is a big move beyond 33,700.

Now, we want all the good from this trade ie the inexpensiveness, yet want to keep the upside open. In such a situation, the butterfly can be modified by reducing the difference between the strikes on the side where we want the profit not to turn into loss.

So here a Modified Call Butterfly could be deployed. Let us try modify the aforementioned trade.

Buy 1 Lot 32300 CE @ 190

Sell 2 Lots 33000 CE @ 55

Buy 1 Lot 33300 CE @ 30 (Modification)

Maximum Profit = 700 (Difference between strikes) – 95 (190 – 110(55 *2) + 30) = 590

Maximum Loss = 110

There is a slight twist because of the nearing of the upward strike from 33,700 to 33,300, now above 33,300 wherever the Bank Nifty goes, there will be at least a constant profit = 400 (reduced difference between the strike sold above) – 110 (Premium Paid) = 290.

In slow but persistently rising current moves Modified Call Butterfly can be best suited to trade a follow-through move without worrying too much about it sustaining those higher levels.

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