Iron Fly: Capped Profits
Tara further asked, “If premiums are high due to implied volatility, what can we do?”
Maya explained, “In high premium situations, you can use the concept of spreads and sell an out-of-the-money (OTM) option for both the call and put to offset some premium. However, this comes with a capped profit. For instance, in the previous scenario, you can sell a 19450 put for 24.5 and a 19850 call for 57.5, reducing your premium by 82 points. This is known as the Iron Fly strategy. The payoff graph for Iron Fly looks like this:”
Continuing the discussion, Tara asked, “What if we don’t expect a major move? Can we benefit from the theta decay of extrinsic value of options?”
Short Straddle: Embracing Low Volatility
Maya replied, “Absolutely! In such cases, instead of buying a straddle, you can sell both a call and a put option with the same strike price and expiration date, creating a Short Straddle. However, keep in mind that short straddles have a higher risk profile due to unlimited risk.”
“In our Nifty example, selling both a 19650 strike call and put of the near expiry results in a maximum profit of the total premium of 242,” Maya elaborated. “However, losses will incur if prices move beyond 19650 plus or minus 242. Here’s the payoff graph for a short straddle.”
Concerned about the unlimited risk, Tara asked, “How can we protect ourselves in a short straddle?”
Maya advised, “You’re right; the risk is significant in a short straddle. To protect against unlimited losses, you can set up a stop-loss order for the increase in total premium. Additionally, if the underlying asset starts moving significantly in one direction, you may consider buying back the corresponding option to partially or entirely close the position.”
Short Iron Fly: Managing Risk
Maya further explained, “You can convert your written options to credit spreads by buying an OTM option for both the call and put as a hedge, capping your maximum loss. This strategy is called the Short Iron Fly.”
“For instance,” Maya continued, “if we buy a 19450 put to hedge the sold 19650 put and buy a 19850 call to hedge the sold 19650 call, the total premium of buying the hedge (82 points) is subtracted from the maximum profit.
Here’s the payoff graph for a Short Iron Fly.”
Tara appreciated the risk management aspect of the strategy.
Maya emphasized, “The most crucial aspect of trading is to keep control over your losses. Profits may not always be in your control, but losses should be. Focus on what you can control—your risk and your losses—letting profits take care of themselves.”
To be continued…
(The author is CEO Yubha.com, TradingHeads.com)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)