The butterfly spread is a popular options trading strategy employed within the Nifty option chain. This strategy aims to profit from the expectation that the underlying asset’s price will remain relatively stable within a specified range. Check on how to make demat account. The butterfly spread involves a combination of call or put options with three different strike prices. In this comprehensive guide, we’ll explore the butterfly spread strategy in the Nifty option chain, including its components, how it works, and when to use it.
Understanding the Butterfly Spread:
A butterfly spread is classified as a neutral strategy, and it can be implemented with either call options or put options. It derives its name from the shape of the profit and loss (P&L) graph, which resembles a butterfly. Check on how to make demat? The strategy involves three legs:
Long Option Position: The butterfly spread begins by purchasing two options, one with a lower strike price (K1) and one with a higher strike price (K3). These options are typically referred to as “wings.”
Short Option Position: Simultaneously, the trader sells one option with a strike price in between the two purchased options (K2). This option is often called the “body.” Check on how to make demat account.
The butterfly spread is used to take advantage of low volatility and is generally employed when a trader anticipates minimal price movement in the underlying asset, in this case, the Nifty 50 index.
Components of the Butterfly Spread:
Let’s break down the key components of the butterfly spread:
Strike Prices (K1, K2, and K3): The effectiveness of the butterfly spread relies on selecting the appropriate strike prices. K2, the strike price of the short option, should be the one closest to the current Nifty index value, reflecting the expected stable range. K1 and K3 represent the strike prices of the long options, with K1 lower than K2 and K3 higher than K2. Check on-how to make demat?
Expiration Date: All three options within the butterfly spread should have the same expiration date. This synchronicity ensures that the strategy remains within the specified range during the entire life of the options.
How the Butterfly Spread Works:
The butterfly spread involves the following actions:
Buying one option with a lower strike price (K1) and one with a higher strike price (K3).
Simultaneously selling one option with a strike price between K1 and K3 (K2). Check on-how to make demat?
The profit or loss from the butterfly spread depends on how the Nifty index performs at expiration. The maximum profit occurs if the Nifty index closes at K2 at expiration, while the maximum loss occurs if the Nifty index deviates significantly from K2 in either direction.
When to Use the Butterfly Spread in the Nifty Option Chain:
Low Volatility Expectations: The butterfly spread is best suited for situations with low volatility expectations. Traders anticipate that the Nifty index will remain within a specific range without significant price fluctuations. Check on-how to make demat?
Non-Directional Outlook: This strategy is neutral and does not depend on the market moving in a specific direction. Traders use it when they don’t have a strong bullish or bearish bias for the Nifty index.