The Economic Times daily newspaper is available online now.

    Learn With ETMarkets: Options Demystified 504 – Iron Fly and Short Straddle

    Synopsis

    "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:"

    stock-image-1200Agencies
    Continuing from the previous discussion on Straddles: Profiting from Uncertainty

    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:"

    Iron Fly


    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."

    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."
    Payoff


    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)



    (Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)

    (What's moving Sensex and Nifty Track latest market news, stock tips, Budget 2024 and expert advice, on ETMarkets. Also, ETMarkets.com is now on Telegram. For fastest news alerts on financial markets, investment strategies and stocks alerts, subscribe to our Telegram feeds .)

    Subscribe to The Economic Times Prime and read the Economic Times ePaper Online.and Sensex Today.

    Top Trending Stocks: SBI Share Price, Axis Bank Share Price, HDFC Bank Share Price, Infosys Share Price, Wipro Share Price, NTPC Share Price

    ...more


    (What's moving Sensex and Nifty Track latest market news, stock tips, Budget 2024 and expert advice, on ETMarkets. Also, ETMarkets.com is now on Telegram. For fastest news alerts on financial markets, investment strategies and stocks alerts, subscribe to our Telegram feeds .)

    Subscribe to The Economic Times Prime and read the Economic Times ePaper Online.and Sensex Today.

    Top Trending Stocks: SBI Share Price, Axis Bank Share Price, HDFC Bank Share Price, Infosys Share Price, Wipro Share Price, NTPC Share Price

    ...more
    The Economic Times

    Stories you might be interested in