Introduction:
Trading in derivatives, such as Futures and Options (F&O), allows you to make considerable profits with limited capital. You can double or even triple your money within a few months. However, you must know how to immediately use the right options trading strategy. Or else you can even lose your entire capital.
There are several options trading strategies for different market circumstances, including bullish markets, bearish markets, volatile markets, and sideways markets. You need to identify the prevailing market conditions and execute an appropriate options trading strategy to balance potential gains and losses.
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In this article, you will learn about one such strategy – short call butterfly. It is a hedging technique, thus allowing you to make a limited profit with a defined risk. Keep reading to know more about this options trading strategy.
What is a short call butterfly?
The short call butterfly, also known as the short call spread, is a three-part options trading strategy. It involves selling one in-the-money (ITM) call option, buying two at-the-money (ATM) call options, and selling one out-of-the-money (OTM) call option. All options must have the same underlying asset and expiry date, and their strike prices must be equidistant.
The maximum profit you can make is the difference between the premium you will receive by selling two ITM and OTM call options and the premium you will pay for buying two ATM call options. However, it’s possible only if the underlying asset’s price remains above the higher or below the lower strike price at the option’s expiry. On the other hand, the maximum loss you can incur is the difference between the lower and middle strike prices minus the net premium received.
A short call butterfly options trading strategy is helpful during volatile market conditions. You can implement it if you foresee high volatility in the underlying asset’s price. You don’t have to speculate on the direction of the market, but instead, you need to bet on the volatility. You can generate returns through this strategy if the underlying asset's price fluctuates moderately in any direction but with high volatility.
How to construct a short call butterfly?
As mentioned, a short call butterfly is a three-part option trading strategy, involving four call options with three different strike prices. You can create a short call butterfly in the three steps mentioned below:
Step 1 – Sell an ITM call option with a strike price ‘A’
Step 2 – Buy two ATM call options with a strike price ‘B’
Step 3 – Sell an OTM call option with a strike price ‘C’
Here, A, B, and C must be equidistant from each other. Also, A should be less than the underlying asset's current market price (CMP), B should be equal to the CMP, and C should be greater than the CMP.
A Short Call Butterfly: An illustration
Now, let’s understand how the short call butterfly strategy works with the help of an illustration. Suppose the shares of a company, ABC are trading for Rs. 200, and you perceive high volatility in it in the upcoming days. You decide to create a short call butterfly.
- You sell a call option with a strike price of Rs. 180 at a premium of Rs. 9
- You buy two call options with a strike price of Rs. 200 at a premium of Rs. 5 each
- You sell a call option with a strike price of Rs. 220 at a premium of Rs. 4
Considering the lot size of the shares to be 1,000, your initial profit would be Rs. [(9 x 1000) + (4 x 1000) – (10 x 1000), i.e., Rs. 3,000. So, if the price of the ABC shares closes above Rs. 220 or below Rs. 180 at expiry, you will be able to keep your profit of Rs. 3,000. However, if the share remains at Rs. 200, you will incur a loss of Rs. (17 x 1000), i.e., Rs. 17,000.
To conclude
As you can see, a short call butterfly is a limited profit, limited risk options trading strategy for volatile market conditions. Hence, you can use this strategy when you foresee high market volatility in the upcoming days, which may be due to election results, policy change announcements, declaration of quarterly results, etc.
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