Swings in the markets have been out of the ordinary, so much so that the risk barometer, India VIX, went up by almost 6 points in the week that has just gone by.
India VIX is nothing but a number that accounts for perceived volatility from the underlying Nifty Options. This development creates two problems.
One is raising the possibility of drastic swings and second being the dearness in premiums, making it more expensive to trade in them.
This coupled with a lot of change in participation more so unwinding leaves even the forecasting more difficult.
This boils down to the problem – there will be less of directional conviction in the market, reducing the opportunity in trading futures.
Even the options are too expensive to ‘buy’, which leaves us with just one alternative. That is too ‘Sell’ Options. Well, at that this juncture you will have a brave heart to Sell naked Call/ Put.
Does that mean we stay away from Trading?
With close to 200 million combinations, we strongly believe that we can definitely have a solution to this problem. One strategy that does it well is a Butterfly.
What is a Butterfly?
It is a four-legged strategy, but don’t despair as they are there to add to extra protection.
The butterfly can be formed by Selling 2 Lots of a particular strike Call/Put & buying one higher Call/Put & one Lower Call/Put of the equal distance up and down.
For example, keeping the center strike at 10500 for creating a Call Butterfly one would Sell 2 Lots of 10500 Call. Keeping the distance of 300 points, one would Buy 10200 Call & 10800 Call simultaneously.
The cost of the strategy is just the net premium outflow that you would have on this trade (Plus the Margin for short Options). That in itself is the Maximum Loss.
On the other hand, upon expiry Strategy gives 300 (the difference) – Net Premium Outflow as maximum profit. At Friday’s close, same trade would cost mere 30/- per piece, while the Maximum profit would be 270/-.
The only weak point is the profit can be maximized only at one point which is 10500. However One would get at least 1:2 Risk-Reward if Nifty were to expire between 10300 & 10700.
The best application of this is for those who would be keen on trading freshly emerged weakness or ones looking to bottom fish. With premium outflows so low, it does not matter if one were to go wrong.
Now just make one little change i.e. move the centre strike to your Target either Up with all Calls or Down with all Puts.
You have the most economical way to trade. The best part is if the Premiums were to fall due to reduction is perceived risk or if the stock were to move in the direction of your centre strike.
The strategy would also give tiny but more consistent trading profits over time.
Disclaimer: The author is CEO & Head of Research at Quantsapp Private Limited. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. .com advises users to check with certified experts before taking any investment decisions.moneycontrol