Last week, we discussed the modified butterfly strategy, a strategy in which the distance between the higher shot and the middle shot is less than the distance between the middle shot and the lower shot. What if you implement a mod butterfly strategy where the distance between the middle strike and the lower strike is less than the distance between the upper strike and the middle strike? This week, we’ll discuss when this strategy is attractive.
The maximum gain of a mod butterfly is the same as the maximum gain of a regular butterfly. This means that the difference between a mid hit and a down hit is important, as it determines the maximum gain from mod Butterfly. Wouldn’t the strategy be unattractive if the distance between the middle strike and the lower strike was smaller than the distance between the upper strike and the middle strike?
Consider a strategy where you are long one 19900 call option contract for next week on the Nifty index, short two 20000 call option contracts, and long one 20100 call option contract. The position can be set to a net debit of 15 pips. Therefore, the maximum gain is 85 points. However, what if you modified this strategy to be long one 19900 call contract, short two 19950 call contracts, and long the 20100 call option? You can set up a position with a net credit of 39 points because the short middle line is closer to the long lower line. The maximum return is 89 points, which is the difference between the strike prices (19950 minus 19900) plus the net credit. Therefore, the maximum gain is higher than that of ordinary butterfly.
But what happens if the underlying asset trades above 20,100 when the option expires? The position could lose about 60 points. In fact, if the underlying asset trades at the higher strike price or any price above that, the strategy will lose 60 points. This is because the strategy has a naked short position in the 19950 call option and will suffer losses if the underlying asset trades between 19950 (the middle strike) and 20100 (the higher strike). Note that a short 19950 call is covered by a long 19900 call. The greater the distance between the upper and middle strikes compared to the middle and lower strikes, the greater the potential losses from this strategy.
The strategy gains from the intrinsic value of the lower strike call option and gains from the time decay of the two short-term mid-strike calls.
The mod butterfly strategy discussed above would be the best choice when you expect the underlying asset to make little to no movement or at most a small upward move. The strategy gains from the intrinsic value of the lower strike call option and gains from the time decay of the two short-term mid-strike calls. If you are setting up a mod butterfly strategy, it is best to create a strategy with a smaller distance between the higher strikes and the middle strikes, which is the strategy we discussed last week.
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