BAJAJ BROKING
February 18, 2025
6 mins read
Short call butterfly is a popular options trading strategy, which is used when market participants expect low volatility in a security’s price. Read more..It enables them to earn return without the need to predict the direction of the price movement. Instead, they bet on volatility in a manner that limits the downside of their position and earn limited returns as well. Read less
There is no denying that options trading exposes you to price volatility. If not managed well, volatility can make you incur huge losses. However, if you implement the short call butterfly strategy correctly, you can limit your risk and earn a limited reward as well. So, let us discuss how we can implement the short call butterfly strategy in detail.
A short call butterfly is an options trading strategy that is used when a trader expects low volatility in an asset's price. This strategy helps a trader generate returns without having to forecast the direction in which the price will move. Instead, the trader bets on volatility while limiting the downside of his position and generating limited returns.
A trader should use the short call butterfly strategy when he expects low volatility in an asset’s price. Moreover, he believes that the price will remain somewhere near the middle strike price at the expiry date. This strategy is ideal when a trader thinks that an asset’s price is not going to change significantly. Hence, he wants to profit from time decay and a stable market. This is the reason this strategy works well when implied volatility is low but limited movement is expected.
A trader can create a short call butterfly by selling one ITM (in-the-money) call option, purchasing 2 ATM (at-the-money) call options, and selling one OTM (out-of-the-money) call option of the same underlying asset with the same expiry date, which will give him a net credit to enter the position. He can customise the strike price based on his convenience. That said, he should ensure that the lower and upper strikes are at an equal distance from the middle strike.
Strategy | Sell 1 ITM Call, Purchase 2 ATM Calls, & Sell 1 OTM Call |
Market Forecast | The movement must be on or above the sold strike price & bullish on volatility |
Objective | The trader should try to correctly predict the movement in an underlying security in either direction |
Upper Breakeven | Higher Strike price of short call + Net Premium Received |
Lower Breakeven | Lower Strike price of short call + Net Premium Received |
Risk | Low (Maximum loss is incurred only if the price of the underlying asset is significantly away from the middle strike price) |
Reward | Limited to the Extent of Net premium received |
Margin Needed | Yes |
Now, let us delve deeper into how to execute the short call butterfly strategy.
How to Trade the Short Call Butterfly?
Let us take an example to understand this strategy better:
Suppose Nifty 50 is currently at 22,000 points. You think it will stay around 22,000 points by expiry. Hence, you expect low volatility. In order to implement the short call butterfly strategy, you need to follow these steps:
Sell 1 call option with a strike price of 21,900. You expect Nifty 50 to be at around 22,000 at expiration. Hence, this call is in-the-money (ITM) because it allows its holder to buy Nifty at less than 22,000 from you.
Purchase 2 call options with a strike price of 22,000. As these two calls have a strike price of 22,000, they are at-the-money.
Sell 1 call option with a strike price of 22,100. As this call option’s strike price is slightly higher than the current level of Nifty 50, it is out-of-the-money (OTM).
How this Works:
a) You receive a premium by selling two call options.
b) But, you pay a premium for buying two call options.
c) You think that Nifty will be around 22,000 by expiry. If it indeed stays at 22,000, the two calls you purchased at 22,000 will be worthless. And, you would have lost premium on them. The one call option you sold at 22,100 will also be worthless, but you would have earned premium on that. Meanwhile, the one call option you sold at 21,900 will make you incur a loss, as its holder will buy Nifty from you at 21,900 when its current price is 22,000. That said, you would have earned a premium on it.
d) In case, Nifty moves far away from 22,000 (either increases to 22,100 or falls to 21,900), you will incur a loss but it will be limited because of the way you have structured your strategy.
If Nifty increases to 22,100, you will earn a profit on two call options you purchased at 22,000, but you would have paid a premium on them. Besides, the one call option you sold at 22,100 will be worthless, but you would have earned a premium on it. However, the other call option you sold at 21,900 will make you incur a loss, but you would have earned a premium on it, too.
Conversely, if Nifty falls to 21,900, the two call options you bought at 22,000 will be worthless and you would have also lost premium on them. The two call options you sold will also be worthless, but you would have earned a premium on them.
There are a few things, which must be kept in mind while using the short call butterfly strategy. First, its objective is to profit from low volatility in an asset’s price. Second, it aims to take only limited risk, which is possible because it focuses on scenarios involving low volatility. Third, the strategy offers limited profit potential, which makes sense because it focuses a lot on keeping the risk limited. With limited risk, you can earn only limited profit. Fourth, it can result in losses, but those losses are not likely to be significant.
The following Option Greeks help traders understand how an option’s price changes in response to various factors:
Delta: Delta is an indicator that tells us how much an option's price is likely to change in response to a change in the price of the underlying asset. The delta of a short call butterfly strategy tends to be close to zero.
Vega: Vega is a metric that tells us how much an option's price can change in response to the changes in the volatility of the underlying asset.
Theta: Theta is the measure of the time decay in the price of an option. In other words, it tells us how much an option's price is likely to decrease as its expiry date approaches.
While the short call butterfly strategy offers limited risk, it requires experience and a considerable degree of skill to execute. When the expiration date of options approaches, a small change in the underlying asset's price may have a considerable impact on the price of the short call butterfly spread. Hence, it is advisable to use strict stop loss to restrict losses.
If you are about to open a demat account, you should not straightaway start using the short call butterfly strategy because executing it could be a challenge. Instead, you must first learn how security prices behave in the market while improving your understanding of options. Only after developing a sufficient understanding should you implement the short call butterfly strategy.
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Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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You can use this strategy when you expect low volatility in an asset's price and also minimal price movement. Besides, you aim to profit from time decay and hope the asset will remain near the middle strike price at expiration.
To do so, you have to sell 1 ITM call option, purchase 2 ATM call options, and sell 1 OTM call option of the same underlying security with the same expiry date, which will give you a net credit to enter the position.
In this strategy, the maximum loss occurs when the underlying asset’s price moves considerably away from the middle strike price.
You can earn the maximum profit in this strategy when the price of the underlying asset is exactly at the middle strike price at the expiry date.
“IV” stands for “implied volatility,” which measures the future volatility of an option.
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