Shubham Agarwal explains how to use Iron Butterfly strategy

Option writing has always been an enticing area of option trading. So much so that nowadays, we have a sizable portion of options traders who love to concentrate their entire trading activity on option selling. It should not come as a surprise that history has it that more than half of the options ever created have turned to zero.

With favorable odds at all times, it makes sense to be selling options. If that is the case, then why do people buy options? Well, the rather dark side of this shiny option selling is that while the odds of winning are favorable but at the same time the reward to risk is equally or at times exponentially unfavorable. With this unattractive factor of writing comes the Dilemma.

Option writing thrives on the principal of time value decay. Options being perishable in nature continues to lose a portion of its value as the time passes by. This decay in values is as certain as Death and Taxes. The intensity and interest of options selling has increased multifold after introduction of weekly expiries.

This is because another interesting fact about the time value decay is that closer the expiry higher will be the speed of this decay. So, the speed one used to get in last week of the monthly expiries is now experienced in every week.

Writing Options for a few hours towards the end of the day is something a lot of us option writers have done and cherished. Now first dilemma is whether or not to write in such a situation as the swings in last few hours are also brutal enough.

Here, simplest way of taking the trade would be to keep a stop loss of double the premium on either side option. Sometimes however that also may not work. So, resort to Iron Butterfly, which is simply Selling Both Call and Put at the same strike and buying protection a few hundred points away. For instance, If I short 16500 Call and Put on Nifty which fetches me 100/- , I could go and Buy 16350 Put and 16650 Call. The stop loss mechanism will still be in place but in no situation the losses will go beyond control.

Similarly, this can become an effective way of trading short option strategies ahead of weekends, especially the long weekends. Here the protection works most effectively because the opening gap moves are one of the most common reasons many option traders would avoid going short on options ahead of a weekend.

The strategy of Iron Fly would definitely suppress the profits. But, with protection comes peace of mind led by finite loss potential. Here, many Iron Fly traders do take the liberty to show the aggression in choosing the protection. There is no harm in it as long as we are at peace with the loss potential. Forwarding the aforementioned instance, an aggressive trader may go long on 16750 Call & 16250 Put. This is because just like our annual life insurance, these are also foreseen to be turning to zero.

Nonetheless, writing without protection brings in the most gains but I would still recommend to buy protection against your short options, however farther they may be. And Iron Fly is the best way to do so.

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