India’s Most Volatile Bank Nifty registered a low of 43,858 on 4th October. This week was a good time to understand how ratio traders, especially butterfly strategy’s function. While most market participants were anticipating a breakdown below 43,500 this week. The institutional traders took advantage of the situation and made a smart move. They forced the index to remain inside a range of 1,000 points after it touched 43,800 levels (Spot). The question is how did they do it?
Picture Source :- Fisdom.com
The Institutional Spread (Butterfly)
You’ll notice, Bank Nifty registered a flat opening this week around 44,445 (Spot). The index then registered a high of 44,755 but failed to cross 28th September’s high which was 44,757. Hereafter, Bank Nifty slipped into a narrow curvature. The question you want to ask is, “Why Bank Nifty slipped into a range? Was it indicating anything? Always remember, unless the Vega expansion in Bank Nifty meets the required criteria, the market maker will use these pop-up moves going forward to adjust the squeeze in option premium in their favour. This week was one such week. Everything was explained in the recent newsletter
Although Bank Nifty had closed successfully below 44,400 according to premium calculations, last few weeks premium movements in call strikes across made us realise that if market falls quickly, it’ll end up giving a quick short covering at any time because puts were attracting instant demand which were being nullified as soon as market maker achieves its target. In such cases, initiating a trending positional trade can be fatal.
Introducing, BUTTERFLY Strategy. These ratio spreads are maximum loss strategy, which means, even if circuit comes in the market, you’ll end up losing the debit in that spread, that’s it. Hence, butterfly always gives an amazing R: R trades in range market. This spread involves buying one option, selling the nearest OTM option twice and again buying a far OTM option to avoid any sudden volatility.
When To Create Spreads
So, how do institutional traders understand that they should create spreads? The first thing we must understand is, they create spreads either to eat up time decay or drift along with the shift in market volatility. So, the market makers track the options Vega very closely. We all know that both time and volatility are essential components for the option buyer to generate profits. And that is exactly what they try to offset. This phenomenon is very similar to a time stochastic process where the value of the option premium melts away causing damage to the option buyer’s position. Unless any surprise event is triggered, the market maker has enough room to adjust the position in his favour as time continues to slip away. This is exactly why you’ll notice that the option you buy, sometimes will not generate returns despite trading on the right side of the trend.
We took advantage of the situation as we realised 44,400 PE buyers were active but were not expecting a crash in next few days as 44,100 PE were about to attract sellers in the range of INR 250-280 (Check the high of 44,100 PE ). We created a butterfly with 44,400 PE - 44,100 PE – 44,000 PE. Debit was INR 90 and to offset the cost, we sold 4,600 CE and this spread now was initiated at the debit of INR 34.
This Butterfly Spread was closed at a whopping INR 186. A clean 150 points in a maximum loss strategy. That’s how Amplify did it!