Markets have been consolidating in a narrow zone for the past few weeks and it has made it difficult for directional option traders to find opportunities as the movements in many cases are not able to surpass the theta cost. This type of market demands a temporary change in strategy and for some time till the consolidation continues, deploying some oscillating strategies can be preferred over directional bets.
I’ll talk about two such strategies today – Butterfly & Condor. Both butterflies and condors are four-legged strategies. These strategies are a hedge and do not have an unlimited risk scenario.
Due to its inherent attribute of being a hedge, the margins of these strategies are comparatively low over naked option writing. As we are adopting these strategies for a tactical shift from directional bets, if the market again changes from oscillating to trending, these strategies will offer lower risk. The reward to risk payoff is also high if the strategy works in your favour.
Butterflies
Butterflies are four-legged strategies. The butterfly family of strategies consists of three types of combinations a) only calls, b) only puts, c) a combination of calls and puts. In the first two cases, the trade is constructed by buying one lower strike option, selling two higher strike options, and buying one even higher strike option.
For example, to form a call butterfly, the trader could be buying 1 Lot of ITM options, selling 2 lots of ATM options, and buying 1 lot of OTM options. When creating a strategy with a combination of calls and puts, the strategy construction can be buying 1 OTM put, selling 1 ATM Put, selling 1 ATM Call, and buying 1 OTM call.
The distance between the sold strike is typically equidistant but in cases where the range needs to be customized, both side legs can be of different distance.
Butterflies will have the highest reward if the expiry is near the sold strikes and that is why the sold strikes may not be ATM options but can be customized to the target expiry level.
The strategy should be deployed with short term time scales toward expiry, weekly expiries or few days left to the monthly expiry.
Butterflies are deployed when the expected range of oscillation is extremely small and can be predicted with some level of accuracy. This structure yields a high reward to risk and since most of the data lie around the mean, the strategy can have a high strike rate if is being deployed in the recent range.
Condors
Condors are deployed when the underlying instrument is expected to be sideways. Condors can be preferred over butterflies when the expected range is wider, but this comes with a trade-off of comparatively lower reward to risk.
A condor can be formed very similar to butterflies, but the only difference is that instead of selling two options of the middle strike, here, both the strikes sold will be different. For example, a Call condor on Nifty could be: Buy 1 Lot 15400 CE, Sell 1 Lot 15600 CE, Sell 1 Lot 15800 CE, Buy 1 Lot 16000 CE.
Summary
Market behaviour keeps changing from trending to oscillating, and tactical shifts in types of options strategies being deployed can be customized to the broader trends. Butterflies and condors are safer ways to benefit from these tactical shifts towards oscillating markets.
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