How can a trader handle a period of range trading? Often, there is little to do except wait for a breakout. If liquid options are available on the underlying, more strategies are available. But option strategies to exploit ranged markets are expensive.
The most effective method involves butterfly spreads. These are somewhat complex and require taking four positions. These can involve directional calls. It starts with the trader guessing where the middle of the trading range will be.
The following prices and premiums are merely illustrative. Brokerage has been ignored. The Nifty is currently trading between 5,600-5,800 and it closed at 5,688 on Monday. Let’s say, the trader thinks the index will end the settlement close to 5,700 – that is his targeted mid-range.
He could take a long call butterfly, buying the in-the-money 5,600c (122), selling two 5,700c (2x58) and buying a long 5,800c (22). This costs 28 and he must also commit margin for the two short 5,700c. The initial 28 payable is the maximum cost. The position gains a maximum profit of 72 if the index expires exactly at 5,700. Breakeven is seen at either 5,628 or 5,772 and the spread loses money above 5,772, or below 5,628.
The trader could also take a long put butterfly targeting the same midpoint of 5,700. Then he sells two 5,700p (2x57) and buys a 5,600p (23) and a 5,800p (117). The net cost is 26, plus margin for the two short 5,700p. This spread breaks even at 5,626, and makes a profit until it hits the second breakeven at 5,774.
The mechanics of butterflies are easier to understand if you remember the trader sells two options at the mid-point and buys one option above, and one option. One of the long options will usually be in the money. The maximum gain is at the mid-point. If the short options are struck, the losses on one short option is cancelled out by gains on the in-the-money long option. The losses on the other short option are partially compensated by gains on the other long option, until the second long option is struck.
The trader shifts the target if he has a directional bias. In our example, if he assumes expiry will be close to 5,600, he will sell two 5,600p with one long 5,700p and one long 5,500p. If he assumes expiry close to 5,800, he can sell two 5,800c, and buy a 5,700c and a 5,900c.
Brokerages for butterflies are obviously high. So are margins, given the short positions. In practice, there is little profit to be made from these except by holding till settlement. So these positions are more tempting in the last week or so of settlement.
The author is an equity and technical analyst
