STRADDLES, STRANGLES AND BUTTERFLIES …

Can you summarise the discussion last time?

Last time we discussed about strategies which you could follow if you believe that the market will stay neutral or will become volatile. In that context, we discussed straddles and strangles.

More suggestions on straddles and strangles?

As a seller of these strategies, you are open to unlimited risk. Most option writers would prefer to sell strangles rather than straddles. As you are aware, a straddle sale comprises of a call and a put sold at the same strike price. For example, if you sell a Satyam 240 Strike Straddle with Call and Put premia at Rs 11 and Rs 13 respectively, you will receive Rs 24 as Income and the two break even points will be Rs 216 and Rs 264 respectively.

If Satyam moves below Rs 216 or Rs 264, your losses are unlimited.

In a Strangle, the loss range becomes wider as the Call and Put are at different strike prices. For example, you could sell a Satyam 220 Strike Put at Rs 5 and a Satyam 260 Strike Call at Rs 6. While you could earn lower premium of Rs 11 (as against Rs 24), your break even points are much wider at Rs 209 and Rs 271 respectively.

So what is the conclusion?

As a seller of options with a neutral view, you should sell strangles rather than straddles – this is a relatively lower risk lower return strategy.

What would I do as a buyer?

As a buyer of volatility, you would rather buy straddles most of the time (rather than strangles) as you would expect to profit faster in a straddle than the strangle. You would consider the premia that it costs you to buy a straddle, but if that is reasonable then you would actively pursue this strategy.

The pay off diagrams of the straddle and strangle for the buyer and seller are presented here for your easy understanding:

Straddle Buyer 

Straddle Seller

What is a butterfly? 

If you are a seller, you are exposed to unlimited losses in both straddles and strangles. This profile may make you uncomfortable and you might like to reduce or limit your loss possibilities.

The butterfly strategy helps you to achieve this result. You would in this case, cut the wings of your straddle. To cut the wings, you would buy a Call with a higher strike price and buy another put with a lower strike price than that of the Straddle.

Example:

You have sold a Straddle on Satyam with Strike Price 240 and generated an Income of Rs 24 (as above). You could buy a 260 Strike Call for Rs 5 and buy a 220 Strike Put for Rs 6. This would cost you Rs 11, thus reducing your Net Income to Rs 13. It will however insure you from losses at both ends.

The final payoff table will emerge as under:

Thus, you will generate a maximum profit of Rs 13 if Satyam remains at your Straddle Strike price of Rs 240. Your maximum loss is restricted to Rs 7 which happens when Satyam moves either below Rs 220 or above Rs 260. This loss is capped on both sides.

The payoff diagram for Butterfly appears as under:

Why should I use Butterfly as a Straddle Buyer?

As a Straddle Buyer, you are paying a fat premium (e.g. in the above example Rs 24). This premium is paid for the gains that you might make for unlimited possible movement in the stock. Now you might expect that the stock might not move unlimited both ways. For example, you might believe that Satyam might rise but not above Rs 260 and might fall but not below Rs 220.

Why should you therefore pay for movement which in your opinion might never happen? You should in that case, sell a 260 Call and generate Rs 5 as premium income. Similarly you should sell a 220 Put and generate Rs 6 as premium income. This will have two impacts:

One – you gain Rs 11 as income, thus reducing your cost to Rs 13 (from Rs 24)

Two – you are giving up gains above Rs 260 and below Rs 220

Any limitations of Butterfly?

The main problems with these strategies which require you to enter into a number of transactions are as under: 

• Several transactions result into high brokerage costs (to enter into a butterfly and then square up makes it 8 transactions);

• Liquidity might not be available at all strike prices;

• All four transactions might take time to execute at your desired prices – if prices change in the meantime, you might find the butterfly payoffs do not occur as you desired

Conclusions:

Straddle, Strangle and Butterfly are very useful and practical strategies for neutral and volatile views on the market (index) or on individual stocks. You need to have a clear view and need to pick underlyings with good volumes and liquidity in order to execute these strategies well. You also need to keep one eye on volatility all the time.

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