Tag: options

Monthly moves

We saw that the NIFTY’s median move over a 30-day period is over 1% and that is all that is required to make a short-call butterfly strategy profitable. Let us now do a quick back-test to check if it is indeed the case.

Back-test

Here is the short-call butterfly back-test from 2010 through now. You basically sell the closest expiry butterfly at each expiry (click to embiggen):

Summary

While it is true that a 1% move in the NIFTY results in a profitable trade, there are instances where the NIFTY doesn’t move +/-1%. When the NIFTY ends flat, you end up losing all your prior profits. Understanding what drives NIFTY to move is key to managing your risk while running this strategy.

Nifty Rolling Returns

In our earlier post, we saw how selling NIFTY butterflies has been profitable this year. To understand why, let’s have a look at the rolling returns of the NIFTY.

Here’s the 30-day rolling returns of the NIFTY, from 2010 to the present, the whole population:

Median: 1.57%

2014-present:

Median: 2.18%

Beginning of 2015-present:

Median: -1.08%

Profitability

For a short-call butterfly to be profitable, NIFTY has to expire away from the either of the wings. Each wing is 100 points away. With NIFTY at 8500, that’s a 1.12% move. Whereas back when NIFTY was around 6000, this trade would require a 1.67% move to be profitable. So as the NIFTY rises, if they don’t widen the distance between the listed strikes, your hit ratio with selling butterflies will increase. However, the total profitability will decrease because everybody will think this way.

Summary

If NIFTY continues to exhibit the same pattern of returns, a rising NIFTY will make selling butterflies more profitable.

What is it?

An option butterfly strategy can be used to bet on underlying volatility. A long call butterfly can entered when you think that the underlying will not rise or fall much by expiration. Using calls, the long butterfly can be constructed by buying one lower striking ITM call, writing two ATM calls and buying another higher striking OTM call.

For example, with the NIFTY at ~8330, the strikes would be 8300, 8400 and 8500. If the NIFTY bends between 8310 and 8490, you make a profit of ~Rs. 90 per contract (x lot-size) and your downside (max loss) is limited to the premium you paid (~Rs. 10 per butterfly contract x lot-size.)

To get a sense for how your P&L will look, you can project the option premiums using the Black-Scholes model.

The solid black line is the P&L scenario at expiry. As you can see, intermediate P&L bears very little resemblance to expiry. It is almost as if most of the P&L is “pulled” as you get nearer to expiry.

Projection vs. Reality

Back in early April this year, the NIFTY was trading around 8600. So you would enter into an 8600, 8700, 8800 butterfly. If you sold the June butterfly, you are essentially betting that the NIFTY would expire outside of 8605 and 8795. If it did, you would get to keep the premium you received (~Rs. 5.70 per butterfly.)

Here is how the butterfly actually behaved:

As a seller, your P&L is actually the inverse of what is shown above. So you would have lost a lot of money when NIFTY shot to 8800s and then swung the other way as NIFTY headed back down. Finally, as you neared expiry, your P&L approached the premium you received.

As you can see, actual behavior bears very little resemblance to modeled behavior.

Butterfly profitability

Selling butterflies has been a profitable trade this year. As long as there is volatility, a short call butterfly should make money. Here is the long P&L (selling butterflies would invert this P&L):

However, it is a bet on the NIFTY not expiring within the break-even range of the trade. Getting this right could prove tricky. Losses tend to be large and if risk is not managed properly, it can wipe out all the profits made over a period of time. The proverbial “picking up pennies in front of a bulldozer.”

Summary

To point out the obvious, liquidity is a huge problem while executing on this trade. However, selling butterflies can be used to systematically earn carry, as long as risks are managed.