The butterfly option

If the bet is on continued range-trading, option combinations like butterflies could work well.

Among the most difficult tasks for a technical analyst is to judge time and direction of breakout from trading ranges. Every time the price tests support at the lower end of the range, or tests resistance at the upper end, there’s a tough decision: will range-trading continue, or will there be a breakout?

Since price moves are fractal, scales can vary. Range trading can last for minutes, or persist for months. There’s no single strategy that works everytime. But trading strategies can be constructed to take both a possible breakout, as well as continued range-trading, into account. The only convenient way to do this is via options. So such strategies can only be implemented in an underlying such as an index, with a highly liquid option market.

 

There are two rules of thumb. One is, given volume expansion, the breakout trend will last until the price moves around the width of the previous trading range. That is, if the price range traded say a 200-point range, the breakout trend will last 200 points. Without major volume expansion, the breakout may be a false signal and the price may revert back to range-trading.

Keeping this in mind, let’s look at the current pattern of Nifty movements. Since late March 2011, the market has oscillated between 5700-5950. That’s a 250-point range – roughly 3-5 per cent. As and when there’s a breakout, we’d expect the same sort of trend with a 200-250 point move. The index frequently moves 1.5 per cent a day (the 30-session average). So, a breakout and target fulfilment could happen within just two or three sessions.

In terms of volumes, the 5-session average of 11.5 crore Nifty shares is appreciably below the 30-session average of 14.5 crore. A drop in volumes is normal for a range-trading period. We’ expect any valid breakout to come with a volume jump, probably exceeding the 30-day average.

We can take a look at the accumulated Open Interest (OI) positions in Nifty options since trader expectations are mirrored by outstanding OI. There are excessive OI bulges at points where a lot of traders expect the next breakout to go.

There’s a huge bulge in OI at the 6000 call (premium 22) and a smaller bulge at 6100c (9). There’s a similar OI bulge at 5700 put (36) and a smaller bulge at 5500p (9). Consensus trader expectations for a breakout in the April settlement would therefore, fall within 5500-6100 – that gels with our rule-of-thumb expectations of 200-250 points.

A trader can either look for continued range-trading, or for a breakout. If the bet is on continued range-trading, good risk:reward equations can be generated using option combinations like butterflies. Butterflies focus on small ranges and maximise returns at the middle of the range.

A long call butterfly between say, 5800-6000 would consist of a long 5800c (95), two short 5900c (49x2) and a long 6000c (22). This costs a maximum of 19. The maximum return of 81 comes if the market is trading at 5900, or close to it, at expiry. Similarly, a long put butterfly could consist of a long 5800p (63), two short 5700p (35x2)and a long 5600p (19). This costs 12 and the maximal return is 88, if the market expires at 5600, or close to it. Obviously any butterfly can also be reversed if there’s a profit accruing prior to settlement.

If a trader expects a breakout, the best shot may be to look for a long strangle triggered by a trending move. For example, a long 6000c (22) and a long 5600p (19) costs 41. Beyond 6041, or 5559, this position could theoretically make unlimited profits.

If the market moves a significant amount in either direction, a trader may be able to reverse a strangle with profits, even if the strangle isn’t struck. For example, if the Nifty rises to 5900, the 6000call will jump in value, more than the 5600put will lose in value. A wider strangle like a long 5500p and long 6100c relies heavily on options being more sensitive to price movements if strikes are closer to money.

A trader may also combine a butterfly with a strangle to cater for both the contingencies of breakout, and range-trading. Or, he may combine a long put butterfly (wins if the market ranges between 5600-5800) with a bullspread that profits on an upside breakout.

The possibilities are endless if there is a liquid options market. This sort of strategy relies more on managing the risk:reward equations than on taking a view as to directions.