The Long Put Ladder Strategy is a trade where you have a mildly bearish view on a stock. Read to know how to trade it well.

Recently I wrote an article on Long Call Ladder, today I will discuss the Long Put Ladder.

The Long Put Ladder is exactly opposite of the Long Call Ladder. Therefore the view of the trader should also be opposite.

In the Long Call Ladder the trader was a bit bullish, in the Long Put Ladder the trader is a bit bearish. In both trades the trades has a bearish view on volatility.

Both strategies are limited reward but unlimited loss strategies.

Why is the trader also bearish on volatility? We will know shortly.

How to Trade the Long Put Ladder Strategy?

If you are bearish on a stock or Nifty you can:

1. Buy 1 ITM (In The Money) Put Option
2. Sell 1 ATM (At The Money) Put Option
3. Sell 1 OTM (Out of The Money) Put Option

Risk is Unlimited & Reward is Limited.

Lets take real prices and discuss one trade.

Date: 11-December-2014
Nifty closing spot price: 8293.00. Option prices are also closing prices.
India VIX: 12.77

Lets trade 100 shares (4 lots) each to keep math’s simple:

1. Buy 24-Dec-14 PE 8,400.00: 98.60
2. Sell 24-Dec-14 PE 8,300.00: 52.30
3. Sell 24-Dec-14 PE 8,200.00: 24.70

Debit: 98.60 * 100 = -9860
Credit: (52.3*100) + (24.70*100) = +7700

So the trader pays money to trade this: 7700-9860 = -2160.

Note: Ideally the ladder trades are played in a situation when the trader gets a credit to trade this strategy. It is because, if his view is wrong and all the options expire worthless, he still gets to keep some money. Go back to the long ladder strategy and see that there the trader was paid a credit to trade the strategy. Though less it makes sense to trade this strategy only when you are getting a credit. However if your view is very strong, you can trade even with a debit.

If you look at the trade closely it is actually a put debit spread with one extra uncovered sold put option. This one extra uncovered put is sold to reduce the cost of buying the ITM put. Usually in the money options are very costly – so the traders look for ways to reduce the cost of buying an option. This is one of the ways.

One more point. It gives a sense of protection too. Because the trader is not selling an option totally unhedged. There are two sold options hedged by 1 bought in the money option. This in the money option will have delta more than any of the sold options. Unfortunately it is still not enough delta to save the trader if an unexpected fall comes through very fast.

If that looks complicated please do not worry. In simple language if Nifty falls the trader is protected to some extent till Nifty reaches 8200 – this is where his worries will begin. Any fall further will be damaging to the trader. Here is where he should take a stop loss. He will still suffer a loss if the expiry is not near, but the loss will be small. Fall after 8200 will escalate the losses fast because 8200 will become in the money.

Now after this discussion lets see his profit and loss on the expiry day.

Case 1) Expiry at the 8400:

All options expire worthless. The trader loses the initial investment of 2160. Anything above the result is same.

Case 2) Expiry at the 8300:

1. Buy 24-Dec-14 PE 8,400.00: (100*100) – 9860 = +140 (Value of 8400 will be 100)
2. Sell 24-Dec-14 PE 8,300.00: 52.30 – expires worthless = +5230
3. Sell 24-Dec-14 PE 8,200.00: 24.70 – expires worthless = +2470

Total profit: 140+5230+2470 = 7840

ROI: For selling 1 lot of 25 shares approx Rs. 13,000 is blocked.
200 shares were sold. 200/25 = 8 * 13000 = Rs. 104,000
For buying 8400 put slightly less money will be blocked as the trader has some sold options too. Assuming 6000 blocked.

104,000 + 6000 = 110,000 blocked for this trade.

(7840 / 110000) * 100 = 7.12% returns. Only 14 days are left for December expiry. So the trader makes a return of 7.12% in 14 days. This is an amazing return. Unfortunately the direction needs to be predicted. If we all could predict the direction we all can be millionaires in no time. 🙂

Case 3) Expiry at the 8200:

1. Buy 24-Dec-14 PE 8,400.00: (200*100) – 9860 = +10140 (Value of 8400 will be 200)
2. Sell 24-Dec-14 PE 8,300.00: 5230 – (100*100) = -4770 (Value of 8300 will be 100)
3. Sell 24-Dec-14 PE 8,200.00: 24.70 – expires worthless = +2470

Total profit: 10140-4770+2470 = 7840

As you can see the results are same as expiry at 8300. But drop from here onwards will be costly for the trader. Let’s see.

Case 4) Expiry at the 8100:

1. Buy 24-Dec-14 PE 8,400.00: (300*100) – 9860 = +20140 (Value of 8400 will be 300)
2. Sell 24-Dec-14 PE 8,300.00: 5230 – (200*100) = -14770 (Value of 8300 will be 200)
3. Sell 24-Dec-14 PE 8,200.00: 2470 – (100*100) = -7530 (Value of 8200 will be 100)

Total loss: 20140-14770-7530 = -2160 (Note that the loss is same as all options expiring worthless i.e. Nifty expiring at or above 8400)

Case 5) Expiry at the 8000:

1. Buy 24-Dec-14 PE 8,400.00: (400*100) – 9860 = +30140 (Value of 8400 will be 400)
2. Sell 24-Dec-14 PE 8,300.00: 5230 – (300*100) = -24770 (Value of 8300 will be 300)
3. Sell 24-Dec-14 PE 8,200.00: 2470 – (200*100) = -17530 (Value of 8200 will be 200)

Total loss: 30140-24770-17530 = -12160 (Note that the loss is Rs. 10,000 more than expiry at 8100. Similarly you can guess the loss if Nifty falls further).

Now an important note:

A good trader NEVER wait tills expiry especially in the trades where he can face unlimited losses. He will surly take a stop loss or do an adjustment to the trade. He knows that sitting on hope is not good way to trade. Therefore I had written that he expects the volatility to decrease.

He has sold 2 options and bought one. So if the volatility decreases, he will profit fast from the sold options to bring down the cash paid to buy the ITM option. This happens especially if Nifty moves up a little or consolidating and volatility drops. In that case he may exit the OTM sold option if he thinks there is nothing much left in that option.

He may choose to exit the ATM sold option too if there is a huge drop in volatility and he is making a good profit on that. If this happens the trader will reduce the cost of buying the ITM option drastically.

Essentially now he can wait for the unlimited profits that may come from a huge fall in Nifty because he has now no more short options left.

This is called smart trading that you must try to accomplish as a trader if the goal is to become a good trader.

Of course if there is a reasonable profit in the whole trade after sometime he will exit from all the three options.

But you should not trade this with the above in mind. Every trade may not result in the same way. It is experience and education that helps determine what needs to be done with the bought and the sold options. Sometimes even after taking the profits from the sold option a trader may have made more had he not bought them earlier in profits.

Some people may not agree to this as they may say its timing of the market. No its not. Once the volatility drops or Nifty inches higher which brings profits to the sold option – its all nothing but simple math’s. Now you just need to calculate the profits from the sold option to see what is the max loss on the trade. If you are comfortable with that max loss now left for the trade, you can take the profits out from the sold options. Since the loss now will be limited.

If Nifty falls, great you make profits from ALL options, else you may have to be satisfied with the loss that you were ready to take anyway. Note that this loss may be more than the initial credit made for the trade, but still much less than had you bought the ITM option unhedged.

Have you ever traded a ladder? If yes it will be great to hear from you. Please do drop a line or two in the comments section.

Thank You.

Directional Trading has lots of benefits as well as risks. You should have strong risk management in place when you take on directional trades.

I started giving 2 conservative directional trades in my course due to the simple reason that almost everyone who called me to inquire about the course said that they like to play directional trades. In fact none of them used to trade non-directional trades, but were interested in them, so asked about the course.

Old habits die hard. I know that even after taking my course some time later they may try a directional trade and end up losing whatever they made in months or even years through the non-directional trading in just one wrong directional play. Yes it can get that risky.

For example lets say in 3 months a trader made around 100 points and took a buy call in Future. Next day Nifty opens gap down 100 points – Bump – Gone! In panic he will cover the Future in a loss. Whatever made in the last 3 months gone in a day. Now start again, very low on motivation. Bad.

Have a look at an email I received recently. See how this trader lost in lakhs trading directional calls/puts.

Directional Strategy Trader Lost Lakhs – Click to Enlarge

This happens to a lot of traders. To overcome this my course now includes 2 conservative directional trades as well, to help traders not lose much money playing directional trades if they are wrong, and make more if right. In fact in the above situation they will make money.

Of course I cannot reveal what’s there in the course but what I can say is most traders playing directional trades are doing it the wrong way.

In this post I will help you know how to trade directional trades better. Please read in full to know.

There are few benefits of directional trades. Here are they:

1. Risk reward especially with options is extremely good. Risk is Limited, Reward Unlimited (on paper 🙂 ). You can actually double your money every month. (Though I guarantee there is no one on Earth who does that.) Some or the other option definitely doubles in 20 trading days. The problem is we just don’t know which one.

If you can know that option, put your money there. Unfortunately its almost impossible to time the markets. And I don’t think there is anyone in this world even with the best technical skills to predict with certainty where the markets are headed and in what time. Well some may be good at predicting whether Nifty will go up or down over the medium term, but no one can definitely predict in what time Nifty will be where.

Since timing of the movement is extremely difficult (well impossible) most option buyers lose money.

2. Risk reward is same in futures. Yes it is same but you can always bring options into the picture to make the risk-reward favorable to you. This is what my directional trades teach. So even if you are 50% right, you should make money.

3. Money comes pretty fast. The beauty of directional trades is that results are pretty fast. You will know in a few days (sometimes the same day), whether you have made a profit or a loss. Great for people who are into the markets for fun.

Yes you may not know, but there are lot of people who are into the options market for fun. One day a trader called me and asked for a strategy that makes money every other day. Tell me how can I help him? Only God can help him. How can there be any strategy that makes money every other day? If you want to make money every other day, you will lose money every other day. In fact you will lose a lot of money every other month. 🙂

Stock markets do not like people who are Greedy. They don’t know but stock markets are rich because of those greedy people. Believe me the only way to make money from the stock markets is to make money slowly overtime. Small profits accumulated overtime becomes huge money.

If you are in the markets to make a lot of money quickly – you may get some fun but no money. After sometime it may not be fun too! Is losing money fun really? 🙂

Please do not live on hope – doubling money every year from the stock markets or making a lakh from a lakh in your account is simply not possible. If you are one of those traders who think that day will definitely come – then let me give some bad news to you – that day will NEVER come.

You will keep on living on hope and losing money doing all the trials and errors in the world. Please do not waste your hard earned money. Be conservative.

So what are the risks in the directional trades? Well a lot.

1. If you make money fast, you lose money fast too. If your risk-reward is not good you will end up losing more than you make.

2. Most traders do not have a proper risk management in place. So what happens is this – when profits come you will take them away in a swift, but when losses comes you will keep waiting for a market reversal. You will keep praying to Gods for help. Was not taking a stop-loss at the appropriate time Gods mistake? Why should Gods help you?

Markets will do what they want to do. They won’t reverse because a trader is losing money. Ultimately when markets do not reverse you will see that you ended up losing 5 times of what you made in your last profitable trade. Losses multiplies by 5 to profits. Frankly this is what I hear from most traders. This will not happen if you have a good risk management in place.

3. Directional trades makes you greedy. Mostly you win the first time. This is called “Beginners Luck“. Once you win you start thinking you have a “God Gift” of predicting markets. Your job is useless. You deserve a better life. You then take a lot of money out from all sources (sometimes even a loan) and gamble in the stock markets taking directional calls. You lose all of it and curse yourself for being greedy. But what has happened has happened. You will not get your money back. Period. Here is one trader who lost more than 40 lakhs because he just couldn’t control greed.

In my course the directional trades are perfectly hedged. So what happens is on Rs.10 invested, you make Rs.7 or you lose Rs.3. When you win you make more, when you lose you lose less. But I have told them to book profits/loss on 100 points at least. The reason is you give room for Nifty to move. And since the losses are less, you can take that chance.

Here is another example of greed. After taking my course one trader mailed me this:

In your directional trade strategy, if I am looking for 25 points as profit and 25 points as stop loss, how to execute this trade?

Which means he essentially wanted to turn it into an Intraday trading and know at the end of the day whether he made a profit or loss. Dude you can find better ways to pass time – markets are not the place to have fun.

When its clearly written you got to wait for a 100 point movement then you got to wait. That is what the strategy was made for in the first place. You just cannot tweak it for fun. People who do not have patience should not trade options in the first place.

This is what I replied:

The problem with small Stop Loss and Profit is that either can be hit very fast – it gets mostly Intraday. Your trade is correct but I do not like trades with no room to move. For example will Nifty go to 8600 or 8400 is an easy guess than Nifty moving from 8525 to 8550.

Another simple example is when you buy a stock, do you buy it to sell it the next day? Ok sometimes it does appreciates in value in 1 day and you can sell to make a quick buck or two. But mostly we buy stocks to keep them for a long period to make money right? When we can show patience there why can’t we show the same patience when we trade with options?

Here are a few tips on How To Do Directional Trading:

1. Strict risk management should be in place: Do not trade on hope. Have proper risk management. Always think of the worst case scenario. Do not place all your money in a single trade. If that goes bust, all your trading money is gone. You will be left with nothing to trade. You should never be in such a situation. So please trade in small size.

One good risk management is keep your profits double the size of your loss. So if you want to target 50 points as profits, your stop loss should be 25 or max 30 points. Which means if you hit target two times, it will take four failures to undo that. Though.

2. Write your target profit or loss in your trade plan. When that is hit just exit the trade. There is nothing called hope in the stock markets. If target profit is hit, be ready to take those profits. If a loss is hit, just take the loss. No egos on either profits or losses. You made money or lost it. It was nothing else.

3. Reduce your cost of trade: When you buy a call, sell a call. And when you sell a call you should buy a call for protection.

For example if you think Nifty may go up then you may:

Buy 24-Dec-14 CE 8,500.00 151.00
Sell 24-Dec-14 CE 8,600.00 87.25

(Taken from 04-Dec-2014 closing price.)

Had you bought 8500 calls without hedge, the risk on 2 lots is: 151 * 50 = Rs.7,550.00
Whereas because you sold 2 lots of 8600 CE your risk reduces by: 87.25 * 50 = Rs.4362.50

Total money at risk: 7550 – 4362.5 = Rs.3187.50 only.

Can you see the beauty of hedging? Now you can easily wait until Nifty hits either 8600 or 8400. 8600 is where you can take your profits out, and 8400 means you got to take the loss. Yes your profits will reduce too, but the losses will also reduce significantly.

Here is another article I wrote on how to reduce the cost of buying an option.

Imagine the same trade with a 25 points leeway. The trader will hit stop loss most of the times. Where is the money?

You can do the same if you think Nifty will go down, that is buy a put and sell OTM put.

4. If you are trading futures protect yourself from unlimited losses. You can do it by buying some protection using options. This is described in details in my course to do it in the best possible way.

5. Relax: If you are doing it conservatively you can relax and trade freely. If you are taking unlimited risk you can never relax and a non-relaxed trader loses money.

I know most of you take directional trades. Do you do anything to reduce risk?

The Long Call Ladder Strategy is often suggested by experts in the moneycontrol website. I do not know for what reason, but I have read this many times there.

What is the Long Call Ladder Strategy?

This strategy is established when a trader has a slightly bullish view but thinks that the stock will not keep rising up and expire at a certain level not far from the current price. He can then trade this strategy.

The strategy:

1. Buy 1 ITM Call Option
2. Sell 1 ATM Call Option
3. Sell 1 OTM Call Option

Reward: Limited
Risk: Unlimited on the upside till expiry

Have a look at the graph:

Unlimited risk is only when the stock keeps rising beyond the last OTM call sold. On the downside profit and loss depends on whether the trader took a credit or paid money to initiate the trade. Expiry in between the strike prices of call bought and sold results in profits. Max profit is if the stock expires between the call options sold.

Now go back and look at the three steps required to create the long call ladder. If you take out step 3 – all that is left is a debit call spread. In simple language if the stock moves up the call debit spread should make money. However debit spreads are costly. If you buy 1 in the money call option and sell one at the money call option in Nifty and if they are 100 points apart – the minimum difference of points will be 50. Which means you have to pay for 50 points at least to establish step 1 and step 2.

Some people are not comfortable with this, as paying for 50 points is costly. If Nifty does not move up, or goes below and expires below the strike price of the option bought – the trader will lose all 50 points.

To reduce the risk the trader sells another call option further out of the money. This makes sure his losses gets reduced by a huge margin.

A lot of Indian retail traders trade this strategy but do not know that they are trading long call ladder. They feel happy for the fact that they were able to reduce the risk by paying less or getting a credit. On top of that if Nifty actually does not travel beyond the far OTM call option – which seems unlikely when the trade was initiated – then the trader makes more profit.

Little does he realize that he is actually taking a unlimited risk because of one extra sold option. What seems unlikely today my become a reality tomorrow. 🙂

Let me take real example from Nifty.

Trade date: November 25, 2014
Spot Nifty: 8480
India VIX: 13.29

We will trade December 2014 options because time to expiry for the November options is just a few days away that will be risky. We will do it in 100 shares to keep the math simple.

Buy 1 ITM Call Option: 24-Dec-14 CE 8,400.00 @ 187.00
Sell 1 ATM Call Option: 24-Dec-14 CE 8,500.00 @ 123.00
Sell 1 OTM Call Option: 24-Dec-14 CE 8,600.00 @ 73.00

Total credit: (-18700+12300+7300) = 900.

Please note that sometimes a debit may also occur depending on which options were sold. For example the trader can also sell the 8600 CE, and 8700 CE call option trading at 73 and 40 respectively.

In that case the trader will have to pay a debit (-18700+7300+4000 = -7400). As you can see just by shifting 100 points up, the trader have to pay a large debit. On the other hand his chances of profits increases. Now he need not bother up to 8700, but in the earlier trade his stress starts when Nifty reaches 8600.

If you trade the above you will receive Rs. 900 the next day in your trading account. This is not your max profit. Lets discuss the profit or loss on the expiry day.

Nifty at 8400:

All the options expire worthless. You can keep Rs. 900/- you got when you put on this trade.

ROI: (900/120000)*100 = 0.75% (Assuming Rs. 100,000 was blocked as margin for selling 200 shares – 8 lots of 25 shares each – and some 20,000 blocked for buying the ITM option)

Anything below the result will be same.

Nifty at 8500:

8400 CE: will be 100. (-18700+10000) = -8700
8500 CE and 8600 CE expire worthless = 12300+7300 = 19600

Result: 19600-8700 = 10900 (This is your max profit)

ROI: (10900/120000)*100 = 9.08%. Amazing profit in almost 30 days. But please understand that this was possible because Nifty expired at the sweet spot. The sweet spot is between 8500 and 8600 – beyond this the profits will start to decrease and losses will start. Lets see how.

Nifty at 8600:

8400 CE: will be 200. (-18700+20000) = 1300
8500 CE: will be 100. (12300 – 10000) = 2300
8600 CE: will expire worthless. 7300

Result: 1300+2300+7300 = 10900 (This is max profit – if Nifty keeps traveling further profits starts to decrease.)

Nifty at 8700:

8400 CE: will be 300. (-18700+30000) = 11300
8500 CE: will be 200. (12300 – 20000) = -7700
8600 CE: will be 100. (7300 – 10000) = -2700

Result: 11300 – 7700 – 2700 = 900 (Profits reduced by 91.75%)

Nifty at 8800:

8400 CE: will be 400. (-18700+40000) = 21300
8500 CE: will be 300. (12300 – 30000) = -17700
8600 CE: will be 200. (7300 – 20000) = -12700

Result: 21300-17700-12700 = -9100

See how fast the losses are accumulating.

Losses will keep increasing as Nifty keeps rising.

Long Call Ladder Strategy works best if the stock or the index is between the sold options on expiry day. Else the profits may vary depending on the position. Losses starts to accumulate if the stock is above the 2nd call option sold.

Note that some traders sell 2 ATM options instead of selling one ATM and one OTM option to get extra credit. This is not a good trade as the losses starts to accumulate very fast once Nifty crosses the sold option strike.

Strategies are recommended for a reason and if you do not have a very solid reason to change a strategy you should not try it. In most cases you will lose money.

Adjustments to the Long Call Ladder Strategy

1. If Nifty is falling – no adjustments required. Be happy with the 0.75% return that month. Do not bring down the ladder – if Nifty again starts moving up, you may lose money.

2. Rollover to the next option prices 100 points away as soon as Nifty crosses the first option sold strike. In most cases the trade here will be in profit. In that case there is no need to rollover. To get that 9.08% you may rollover and may end up losing money. So be happy with whatever you got. Hard to tell the profits you will receive here as it depends a lot on the option price prevailing at that time.

3. In any case DO NOT let Nifty cross the second call option sold. If it has reached there – it is almost certain that you are in good profit. Theta may have done damage to the sold options by now and the bought ITM option will be in good profit – so the whole trade will be in profit. BUT you will still not receive the stellar 9.08% return if expiry is far away.

Do not be greedy. Nifty may again fall or keep traveling up and a profitable trade today will be in loss on the expiry day. So just take your profits and close the trade. You will get another opportunity to trade. Free your cash for that.

This trade looks easy, but mind it, its not. Why? Lets discuss the reasons.

1. If Nifty keeps falling – your profits are just 0.75%. This is less than what a short-term debt fund returns in a month with zero work or stress. This is not a satisfying return trading options. Sometimes the returns may be lesser or you may have to pay cash to trade ladder. In those cases you may lose money.

2. If Nifty is range bound – you will be eager to take profits because of the fear that Nifty may fall and you may lose whatever money you made till now. You will make a profit but the returns will not be great. This is most likely to happen to any trader.

3. If Nifty keeps rising – greed will come in and you will feel like waiting till expiry to take that 9.08% return only to find on expiry day that Nifty has crossed the second option sold and you may have a loss or small profit.

Therefore it is important in any trade to know well in advance where you shall book your profits or take a loss. Maximum profit and maximum loss in any trade should be known to you – but they should not be the only criteria to take a profit or loss. Your profit or loss should be decided by you as a trader – not what the math are showing.

If you have traded the Long Call Ladder Strategy let us know your trade in the comments section. We can discuss the results. This will also help other traders.

If your view is bearish, you can trade Strip. This strategy is opposite to Strap. The Strip is a modified version of long Straddle.

In a Long Straddle a trader buys ATM calls and puts in the same quantity. However in Strip since his view is bearish, he will buy 2 ATM puts and 1 ATM call.

Here is the construction of the Strip Strategy:

1. Buy 1 Call
2. Buy 2 Puts

These options should be of the same stock/index, strike and expiry.

If the trader is lucky and the down-move actually happens – he will make more than had he implemented just the straddle strategy. Lets look at the following graph:

See that profits from 2 puts are more than 1 call.

Risk is Limited to the price paid to buy the options.
Reward is Unlimited till the expiry of the option.

Please note that the trader can still make money even if he was wrong – but the stock has to move in the opposite direction really fast. The 1 call bought has to beat the cost of buying all the options and still bring in some profits.

When to Trade a Strip?

Suppose a bad news has come and you want to take your chances – you can trade a Strip. Note that technically it is NOT required that you buy only ATM options. You can buy options from any strike but both calls and puts should be of same strike.

One can always ask – why not buy cheaper options of both the call side and the put side. Well yes you will save money but the risk will also increase.

When a news comes in, index and stocks move very fast in either direction. Bad news – means going south, and good means going north.

If the options are far out of the money they will not appreciate in value fast. Chances are even if a movement comes you may not make sufficient money to make the trade profitable. There are two reasons for this:

1. Delta of far OTM options are very small. A 1 point movement in stock will not have much effect on the option premium.

2. Theta will also eat premium everyday. If the expiry is near and the option is still far, it will actually decrease in value even if the stock moving in its direction.

3. After the news volatility crunches. The option premium will reduce anyway. A buyer has to fight this as well.

I hope it is now clear why buying far OTM options is a dangerous game.

How to Trade Strip in the best possible way?

1. Traders don’t try this – but Strip will work better on a stock not on a Index. Because in a stock a movement of 2% is quite easy after a news. However volatility will still be a problem with buyers.

2. Wait for the news to come out. Volatility will crush – you will get options at a cheaper price. But it may crush further. (And this is a big problem. However trading after news is better.)

3. Analyze the news. How bad or good is that.

4. If the news is good trade a Strap. If the news is bad trade Strip.

5. If confused but still bearish, buy just OTM strike 2 puts and obviously that strike is just ITM for the call. You created a Strip highly favoring the bearish markets.

Three things can happen:

1. Stock moves down: Great result. The puts you bought were not very far off from the ATM strike and cheap too. In terms of percentage they will increase very fast. The call will decrease in value – but it will become first ATM and then go OTM. A 100 point movement can bring in good profits. Because when you book profits and sell the call you will still get a good premium. You are already making good profits from the puts. Result: Not a big loss from the call, and great profits from the puts.

2. Stock stays in range: Bad result. If the options you bought were cheap you can hold onto expiration, else you should sell after seeing no movement for the next 3 days. Usually whatever movement has to come it comes in 3 days after the news. Then the news dies down and normal trading begins. Which means there is no point in waiting after 3 trading days. Sell all options bought and book loss/profits.

3. Stock moves up: Good result. The call option was already ITM so, it will have a good delta and will move faster. The two put options bought will lose value fast, but this call option will be bringing in profits. Though since its only 1 lot, you may have to wait for sometime to book profits. Not sure here because a lot of Greeks decide the option price but if the stock moves up 2% up in 2 days – the profit from the call bought should surpass the losses from the puts to a good extend. Remember that volatility has decreased, so 1% movement may not be enough.

Strip and Strap are rarely traded by trades worldwide. The reason being they are skewed towards a direction. Most trades are fed up with directional calls so much so that they start adopting the non-directional strategies. Therefore they buy Straddles.

However with most buyers losing money, after a while they stop trading altogether.

Have you tried the Strip? If yes please share your experiences.

Most retail option traders in India do not know option Greeks or do not care for them. Option Greeks are very vital part of options trading. If you do not understand them, than it is very important to know about them. At least you should have an idea of what they are. Lets discuss them.

The Five Option Greeks:

1. Delta:

It is the amount an option price will move with every 1 point move in the Index/Stock. If expiry is not near, Delta movement is NOT 1 point increase with 1 point increase in the stock. Which means if the stock moves 1 point up, depending on the strike price of the option, the option will move less than 1.

The reason is that you buy option at a lesser price than the stock in cash for the same lot size, so why should you get profits equal to someone who bought the same stock in cash? Of course option buyer’s losses are also less than stock buyers’.

At the money (ATM) options usually have a delta of 0.5. If the stock moves up 1 point – the price of the ATM option will go up by 0.5. In The Money options have more Delta than out of the money options. Deep In The Money options move almost 1 to 1 with the stock. This is reason why some traders prefer buying deep ITM options. If right ITM options will make more than ATM or OTM options.

As an example. Lets assume Nifty at 8000. The 8000 strike price of calls and puts will have Delta of 0.5. Similarly 8100 CE (OTM) may have a delta of 0.4, 8200 CE (far OTM) may be 0.3, and 7900 CE (ITM) may have a Delta of 0.6. Note how they are changing. Deltas are assumed here not real – but you get the idea.

As expiry nears Delta of all in the money options will move very closely with the stock price as there is no time value left. When expiry is very near Delta of all ITM options move towards 1. Delta of all Out Of The Money (OTM) options will move towards zero. Therefore on expiry day the premium of all Out Of The Money options becomes zero and they expire worthless.

Note: Some traders think that a Delta of 0.1 means the option has 10% chance to expire In The Money. Or 0.5 means the option has a 50% chance of expiring In The Money. You got the idea. This is very important figure for option sellers. I do not have any data to prove this to be true. So please take precaution while selling option even if it has a Delta of 0.1.

2. Gamma:

With the movement of the stock someone has to change the price of Delta as the option moves from ATM to OTM and then back to ATM to ITM.

In the example that we described above, when Nifty moves to 8100 – the 8000 CE becomes In The Money and its Delta increased from 0.5 to 0.6, similarly Delta of 8100 CE increased from 0.4 to 0.5. Gamma is responsible for this change.

Gamma controls the Delta. It is the mathematical formulae (a software) that decides the change in Delta based on a 1 point change in the stock. If Nifty goes back to 8000 – the 8000 strike will again become Delta 0.5.

3. Theta:

This factor is known by most traders. Theta is the Time Factor in the option premium. This time factor moves towards zero as expiration approaches. Theta is the amount the premium will decrease for a one-day change in the time to expiration. Theta works on holidays and non-trading days too. Theta behaves differently for different strike prices.

One important thing that needs mention. Considering options expiring in 30 days – Theta for deep OTM (Out Of The Money) and Deep ITM (In The Money) options decrease faster in the first 15 days and almost nothing is left for the last 10 days. However ATM options (and the near strike prices) behave exactly opposite. The speed of decrease in Theta is almost constant till the last 5 days – after this the speed increases rapidly. In the last 1 hour it is the maximum.

Compare Theta to the melting of ice. If you take some ice out of your freezer and observe, you will see that for the next few minutes almost nothing happens, then slowly the ice starts melting. After 10-15 minutes the speed if ice melting increases. The last 2 minutes are pretty fast when the ice totally melts. Theta behaves the same way especially for ATM options.

Option sellers are the one who love to see the Theta of options decreasing – because this is what makes money for them. Most option sellers sell out of the money options – which means they are only selling Theta. They buy back the options when Theta decreases in value significantly to make a profit.

4. Vega:

Is the volatility factor. Vega is the amount option prices will change for one point change in implied volatility. It is a measure of fear or uncertainty in the markets. When a big news is expected – there is uncertainty in the markets – so the volatility too increases. When volatility increases option prices for both calls and puts also increases. When volatility decreases option prices for both calls and puts also decreases. Vega only effects the time value of the options not its intrinsic value.

For example if Nifty is at 8000. Assuming the 7900 call option is available at a premium of 130, then the intrinsic value of this option is 100 (the difference between the spot price and the strike price of the option). The time value is 30. When Vega increases, only the time value is affected. This 30 can increase to say 32 depending on the volatility increase.

Similarly when the news is out and uncertainty dies down, volatility decreases. This in effect decreases the premium of the options. This is where most trades lose money. Vega has such a big effect that sometimes even if the direction is right, an option buyer loses money because Vega decreased.

This happens mostly with call option buyers. Usually when the markets go up, the volatility decreases. Call option buyers are up against Time (Theta), and Volatility (Vega). OTM call option buyers lose money even if the stock goes up because by the time it goes up a significant portion of the premium would already have been eaten by Theta and the decrease in Vega will also reduce the premium.

For them to make money the speed of the stock going up is very important. However put buyers are in slightly advantageous position because usually when the markets fall, the Vega increases and they can benefit. However they are also up against Theta. Here too speed matters, though not as important when the stock moves up.

I am sure you now understand why most option buyers lose money.

In India volatility is called India VIX. NSE (National Stock Exchange) has allowed Vega Trading too. Right now only Futures trading is allowed. But I think too much capital is required for margin. Right now it is only for (HNIs) High Net worth Individuals. India VIX can be found here:

http://www.moneycontrol.com/indian-indices/india-vix-36.html

Lower end of VIX (when sellers get less premium): 10-15
Average VIX: 15-20
High VIX: 20 and above

As an example on 12-May-2014 when the India VIX hit a high of 39.3 because the election results were due, and spot Nifty closed at 7014 the ATM call was at 294 and the put at 244. Total premium a seller would have got: 294+244 = 538

Today is 13-Nov-2014 (almost same days left for expiry for the current month). India VIX is 13.80 (64.88% less than 12-May-2014). Nifty closed at: 8357. Here are closing prices for both 8300 and 8400 strike options.

8300 CE: 122
8300 PE: 42
Total: 122+42 = 164 (69.51% less than total of the ATM options on 12-May-2014)

8400 CE: 61
8400 PE: 79
Total: 61+79 = 140 (73.97% less than total of the ATM options on 12-May-2014)

As you can see for the same Theta left, when Vega is down 65%, the option premium also reduces by almost the same amount.

I hope now you understand how important Vega is for option traders.

Why does premium of options increase when Vega increases?

The reason is simple. When there is uncertainty in the markets no one knows exactly where the markets are heading. The risk during these times are more. The risk is much more for the option seller. Why? Because they are willing to take unlimited risk for a limited profit. When the markets are uncertain and the premium they are getting is not sufficient why would they sell an option and take unlimited risk for a small profit?

For example on 12-May-2014 if the total premium of the ATM strikes was just 150, do you think anyone would have sold these options? If there are no sellers, there can’t be any buyers. And if this happens – options trading will cease to exist. Therefore when Vega increases the option premium also increases to lure the sellers.

5. Rho:

Is the interest rate offered at the banks for a fixed deposit of 1 year. It is the amount an option value will change with one percentage-point change in interest rates. As mostly the interest rates are same for a long period, Rho does not have a big impact on the option prices. Since interest rates are not important lets not discuss this further.

How you can get the Option Greeks while trading?

Your broker should be able to provide you with an option Greek calculator if you are approved to trade options. You may also look online. You need to put in the values like strike price, time left, interest rates etc and the calculator should return the Option Greeks.

How to trade with the help of Option Greeks?

This is a very big topic. You will find books written on this topic alone. However I will tell you what most retail traders do in the US. By default in the US all brokers show ALL the Greeks on a traders screen. They need not use any calculator. Unfortunately in India there is not a single broker that shows them by default. If you know any please mail me or write in the comments.

If they want to sell options, they sell option that has Delta of less than 0.15. Which means they sell deep Out Of The Money options. The idea behind this trade is that the chance of this option to expire worthless is 85%. (1-0.15 = 0.85 or 85%)

If they want to buy, they buy options that have delta of 0.5 or more. Which means they buy At The Money or slightly In The Money Options.

Some traders sell both call and put options – mostly out of the money options. These traders try to keep their trades at Delta Neutral. Again this is a very big topic out of scope of this article. Still I will try to explain in a simple way.

Delta Neutral means keeping Deltas of all the options they sold same with any movement of the stock.

For example if stock moves up – the Delta of the call option will increase. So they will move the position a few points up. Essentially booking profits in the puts and booking loss in the calls – but maintaining the Deltas of the calls and puts more or less same. The idea is to profit when expiry nears. The Theta will decrease rapidly of both the calls and puts when expiry nears. Ultimately both the options will expire worthless.

Profits or losses are known only on the expiry day, or when the trade is closed. If all the delta neutral adjustments resulted in profits then the trader is in profit, else he loses.

Some people write software to automate this trading. Yes you can write a piece of software to automate your trading and strategies. Benefit is that emotions are not involved. I have rarely come across a person who made money doing automated trading.

Frankly it is very challenging to keep a trade Delta neutral. You need to keep a watch on the stock every time and be ready to shift your trades with few points movement in the stock. Lots of trading is involved therefore lot of brokerage also needs to be paid. Profits or not, your broker will thank you for being a Delta Neutral trader. 🙂

If you are on a job or a busy person it is humanly impossible to keep changing your trades to be Delta Neutral. And there is no guarantee of profits either. We don’t trade to waste time and lose money too right? If you are busy and don’t want to trade too much and are happy with small profits month after month I recommend my course. Its much better than wasting money on losing trades that teach you nothing.

This came out to be a pretty long post, still this is tip of an iceberg as far as Option Greeks are concerned. Though, I hope after reading this article you will have some idea about them.

Do ask any questions on them in the comments section. Do you look at Option Greeks before taking your decision on option trading?

More information on Option Greeks can be found here:

http://www.investopedia.com/university/option-greeks/

http://www.theoptionsguide.com/the-greeks.aspx

http://www.optionsplaybook.com/options-introduction/option-greeks/

Though I always promote non-directional strategies, sometimes we as traders want to explore strategies to benefit from a directional movement.

Lets say a news has come in and its a good news. We know for sure that Nifty may move up for sometime at least till people fully digest this news. Strap Options Strategy is good for these times.

Note: Why does a stock or Index gives a knee-jerk reaction when a big news comes in? Because some kind of emotional trading starts taking place. If a good news comes in, most professional traders (who get access to this news much before retail traders) act pretty fast to make a quick buck or two.

Some days don’t we see Nifty jumping up 20-50 points in matter of minutes? Well that was news-based trading. Some big news comes in and a few stocks with lots of weight-age in Nifty shoot up, driving the Index too with them. By the time we, the retail traders realize, its too late. Some of us get caught in a trap (buying high) and ultimately lose money.

So how do we participate in this rally with least amount of risk and still make some money? You can try the Strap Options Strategy.

Lets discuss this strategy:

This strategy is to be traded when your view is bullish on Nifty or any stock. That is when you think Nifty/Stock will move up.

Construction of Strap:

1. Buy 2 ATM Call Options
2. Buy 1 ATM Put Option

Risk: Limited
Reward: Unlimited

Image of the Strap Option Strategy:

As you can see the call side will move up faster than the put side if the stock appreciates in value.

Can you recall something? Isn’t Strap similar to Long Straddle? A Long Straddle is a strategy where a trader has a totally neutral view. There too he buys both ATM Calls and ATM Puts BUT in equal number of lots, whereas in a Strap he buys double the number of ATM calls than puts.

So why should you trade a Strap instead of a Long Straddle when you have a bullish view?

Because if you are right you can make more money from a Strap than a Long Straddle. Calls will multiply 2 folds in profits whereas the Puts will only lose in half that amount. And moreover since option buying involves limited risk, the puts will lose only a limited amount of money and calls will bring in unlimited amount of money. 🙂 (Unlimited is only on paper – a trader must book profit somewhere.)

You must be surprised to know that Strap is not as popular a strategy than Long Straddle and Long Straddle itself is not as popular as direct buying of options. Do you know why? Because when we have a bullish view we all think we are smart enough and can make money and we really don’t need any protection. This is the sole reason why most retail traders lose money. Some lose in lakhs.

Long Straddle is played by many retail trades too. Here the logic is – wherever Nifty goes I will make money – down or up. Aha – only if money making was so easy. Everybody would have done a Long Straddle at the start of every series and made loads of money. Unfortunately we all know its not going to work.

In a Strap there is fear. And the fear is – what if Nifty goes down? Therefore he buys one put for two calls. If Nifty actually falls – the trader will make less profits from put than his loses from calls, but he will lose money, though less. Only exception is that if Nifty moves down pretty fast – than even 1 lot profit from the put will surpass limited losses from the calls. However it seldom happens.

So when and how should you play Strap?

1. When you view is strong and bullish on Nifty or any stock.

2. When the volatility is low.

Note: Usually when a news is expected volatility tends to increase. Because there is uncertainty in the markets. Unfortunately because of this you may have to pay more for the options. This is where it gets very tricky because as soon as the news comes in the volatility gets crushed and the options shrink in value. The trader then gets frustrated. He thinks even if his view was right – Nifty did go up – why is that he is still losing money?

The trader does not realize that volatility decreased and so his option values. That is why its very important that you buy these options at least 5-6 trading days before the news has to come in. It could be that you are in profit even before the news and you can sell them to make a decent profit.

Or, you can wait for the news to come in and let the volatility shrunk.

Unfortunately the problem with this is that Nifty would have already traveled its path – up or down and trader then feels a missed opportunity.

As you can see in both the situations above you have some pros and some cons but my experience says that it is always better to be prepared before the opportunity arrives. Once the opportunity goes it is very hard to make money in the stock market. Yes Nifty may continue the same path for some time, but the shrunken volatility ensures little or no movement in the options values. Which means neither the calls nor the puts will move significantly in premiums.

After a couple of trading sessions the trader seeing his calls and puts eroding in values sells them at a loss. Whereas had he bought them a few days back, he certainly would have been in profits.

3. When the options you are buying are actually ATM or very near ATM.

This is important because if the nearest ATM strike is where the calls are in the money then you pay more for the calls. This is not required. And if they are out of money, then the Put is in the money and you pay more for the put. This again is not required.

Ideally the premium of the calls and the puts should be the same so that you play a fair game. But if its near expiry and not much time is left for the news – you cannot wait for the stock to come to a nearest option in that case you can buy nearest ATM options.

4. When only 5-6 days are left for the current month expiry you should buy the next month’s expiry.

You may have to pay more for the options but at least you will have enough time to book your profits or losses. 5-6 days to expiry means you can lose 100% of your premium if there is no significant movement. This is what happens to most retail traders. They wait till expiry and every money they paid to buy these options goes away.

5. Do not put too much capital on risk.

Though this is a limited loss strategy, you can survive the game only if you are losing a limited amount in a trade. One big blow means you are out of the game forever.

Very Important Note: When playing a Strap do write down your profit and loss target. When anyone is hit you should close your trade. Do not trade on hope. When your profit is hit do not believe that more will come and be greedy. A profitable position today can be in loss tomorrow.

Similarly when in loss do not keep the position open thinking that Nifty will reverse or fall further giving you a profit. Nifty owes you nothing. That may happen or may not – a wise trader should take his profit or stop loss and wait for another opportunity.

Hope that will help you to play Strap the right way. And also give enough knowledge to know when to buy options and why you lose money buying options.

Have you ever traded Strap or the Long Straddle? If yes what was your experience?

This is the last article in the butterfly series.

Here are the rest:

1. Long Call Butterfly
2. Short Call Butterfly
3. Long Put Butterfly

… and this article is on Short Put Butterfly Strategy.

Note that the Long Call and Put Butterfly strategies work when Nifty expiry is very near the ATM strike that was sold. A credit is required to play the trade therefore the trade is called long butterfly.

Short Call and Put Butterfly works when Nifty is more than 100 points away in any direction from the ATM strike on the expiry day. The trader gets a credit therefore its called the short butterfly.

Unfortunately adjustments are costly and are not recommended. Since the risk and reward both are limited – basically a butterfly is a set and forget strategy. If it works – great, else you will have to take a limited loss. Mostly these strategies produce best results on the expiry day. And therefore should be traded 2-3 days before the expiry day.

Since some kind of prediction is required, I personally do not like or trade these strategies.

With the above in mind lets discuss the short put butterfly strategy.

When Should You Trade a Short Put Butterfly?

When your view is that the stock or the Index you want to trade will move at least 100 points away and hopefully will remain there during the expiry. Even if it does not move now, your view is that in due course of time Nifty will move away at least 100 points before expiry. This is a positional trade.

Have you ever noticed that when you want Nifty to move – it does not. And when you do not want it to move – it moves 100 points in no time. That’s stock markets for you. 🙂

Therefore butterfly strategy should be traded when you have a strong view of the spot where Nifty will be on expiry day. Tell me how many times will you be correct?

Its a neutral strategy, but high volatility helps because its a sellers trade and premium is the max profit.

Constructing The Short Put Butterfly Trade

1. Buy 2 Lots of At The Money Put Options
2. Sell 1 Lot of In The Money Put Option
3. Sell 1 Out of The Money Put Option

Risk: Limited
Reward: Limited

Let me get the real closing prices of the options that I will now show you as an example.

Date: October 28, 2014

Nifty Spot: 8,027.60 (markets closed for today)

Will treat 8000 as our ATM strike. Options prices are for options expiring on 30-Oct-2014.

Lets trade:

Buy 2 Lots of 8000 PE (ATM): 16.20 (16.20 * 50 * 2 = Rs. 1620/- Debit)
Sell 1 Lot of 8100 PE (ITM): 66.25 (66.25 * 50 = Rs. 3312.5/- Credit)
Sell 1 Lot of 7900 PE (OTM): 3.30 (3.30 * 50 = Rs. 165/- Credit)

Total Credit: 3312.5+165-1620 = Rs. 1857.50

Note: It does not make sense to sell a lot with a premium of 3.30. I know people do it on the expiry day. Frankly it is not a good strategy to sell options on the expiry day. The risk-reward is pathetic. Just imagine even if you are getting 5 points – that is getting Rs. 250 in one lot for unlimited risk. Is that justified? This is off-topic – but if you are selling options on the expiry day, you are doing a big mistake. Yes it is great to see options you sold expiring worthless and those last few moments are so exiting. But are you trading for fun or to make money? What if something goes wrong? You may have a huge loss. There are better trades. Please stop selling options on expiry day.

Ok. Coming back to the trade. Even though it does not make sense, technically to complete a short put butterfly, I had to do it.

You know what I will do in such a scenario? Being very practical, I will do the rest of the trade but not sell 7900 PE. There are still 2 days left for expiry. I don’t need that Rs. 165/-. That is the max I would gain and frankly it does not bother me. So I will take my chances.

What if next day Nifty suddenly moves down 50-60 odd points, or gaps down 100 points? May be that OTM option will then become 30 or even 50. I will then sell that option and complete the Short Put Butterfly trade. That way my returns will be more. This is called legging into a trade – but lets reserve this for another day.

If you have read the other butterfly trades I have written in my website, you would have realized by now that the butterfly trade is a set and forget trade. You should set it near expiry and close it at around 3.15 pm on the expiry day.

Assuming that we waited for the expiry day, lets calculate our max profit and loss.

Assuming Nifty closed exactly at 8100. (Today is the Oct 14 series expiry and Nifty closed at 8169 – so had I done this trade I would have made the max profit :))

Buy 2 Lots of 8000 PE (ATM): 16.20 – Expires worthless. (16.20 * 50 * 2 = -1620 Debit)
Sell 1 Lot of 8100 PE (ITM): 66.25 – Expires worthless. (66.25 * 50 = Rs. 3312.50 Credit)
Sell 1 Lot of 7900 PE (OTM): 3.30 – Expires worthless. (3.30 * 50 = 165 Credit)

Total Profit: 3312.5+165-1620 = Rs. 1857.50
Anywhere above 8100 closing the results would have been same.

Assuming Nifty closed at 8000:

Buy 2 Lots of 8000 PE (ATM): 16.20 – Expires worthless. (16.20 * 50 * 2 = -1620 Debit)
Sell 1 Lot of 8100 PE (ITM): 66.25 – is now 100. Loss 100-66.25 = 33.75 (-33.75 * 50 = -1687.50 Debit)
Sell 1 Lot of 7900 PE (OTM): 3.30 – Expires worthless. (3.30 * 50 = 165 Credit)

Total Loss: -1620-1687.5+165 = Rs. -3142.50

Assuming Nifty closed at 7900:

Buy 2 Lots of 8000 PE (ATM): 16.20 – is now 100 (100-16.20 = 83.8 * 50 * 2 = 8380 Credit)
Sell 1 Lot of 8100 PE (ITM): 66.25 – is now 200. Loss 200-66.25 = 133.75 (-133.75 * 50 = -6687.5 Debit)
Sell 1 Lot of 7900 PE (OTM): 3.30 – Expires worthless. (3.30 * 50 = 165 Credit)

Total Profit: 8380-6687.5+165 = Rs. 1857.50
Anywhere below 7900 closing the results would have been same.

Return on Investment (ROI):

Assuming Rs. 25000 is blocked for 1 lot Nifty option shorting. 2 options were shorted = Rs. 50,000.00 and Rs. 1620 for the option bought. Total margin blocked = Rs. 51620.

If profit: (1857.5/ 51620)*100 = 3.59%
If loss: (-3142.50/51620)*100 = -6.08%

This means you are risking 6.08% to make 3.59%. For some this is good risk-reward, for some it may be bad. For me it does not matter, since this involves predicting I would rather not trade the Short Put Butterfly Strategy.

This does not mean you should never try this strategy.

Best Time to Trade the Short Put Butterfly Strategy

1. Trade when the expiry is near. Why? Because this is a set and forget till expiry day trade. Your money will be blocked for a long time if you trade much before expiry and risk-reward will be almost same whenever you trade. Why would you block your money for so long? I would trade this just 3-4 days before expiry.

2. Trade when volatility is high. Why? Because you get high premium. Yes you also pay more for buying the ATM options – but if volatility is high you may also get more premium. Remember the total credit on the day you trade is your max profit.

3. If a big news is expected 1 or 2 days before expiry it helps. Why? Because the news will have some effect on the markets. For example yesterday night (India time) a big news came – Fed ended quantitative easing. (Quantitative easing is a funding system where Fed buys billions of dollars worth of bonds every month to pour a giant amount of money into the world economy. Some money of course used to find its way into Indian markets.)

This was a big news awaiting Indian and world markets. This news was coming just a night before the expiry day. Thus during such times the short put butterfly and the short long butterfly trades becomes excellent trades, because there is a high chance that Nifty will move someway or the other. For example today Nifty closed at record highs. It closed almost 1% up from yesterday’s closing. It closed at 8169.

4. If you are getting negligible premium by selling one leg of the trade, you can wait to sell it another time for a better premium. But the choice is yours. In the above case we would have lost that 165 Rupees.

Any Adjustments for the Short Put Butterfly Strategy?

No. Set and Forget. The results will come on expiry day. You know your max risk and max reward, why bother with adjustments. If you rollover your trade then only your broker will make money not you.

So Should You Not Take Any Stop-Loss As Well?

Well frankly this is very tricky to answer. If Nifty does not move, you will start getting bit nervous. If your max loss is something that you can digest, my suggestion is that its better to leave the trade for the expiry day. For example today itself Nifty moved 1%, almost all of that intraday.

Had a trader taken a stop-loss in the morning he would have felt bad. And interestingly that trader would have blamed his bad luck because Nifty moved after he took a stop loss. Was it really his bad luck? Or he did not have patience? Therefore trade with limited number of lots and max loss you are comfortable with, and leave till 15 minutes before expiry.

That ends the series on butterfly trades. Have you ever traded the butterfly. I am sure most of you do. If yes what did you trade? Did you make a profit or loss? Do let me know in the comments section.

Note: From tomorrow Nifty Lot size will reduce from 50 to 25 and the margin blocked will also drop by 50%, so please calculate the profit and loss accordingly.

I have already discussed how to trade Long Call Butterfly and Short Call Butterfly. This article discusses how to trade a long put butterfly.

Note: Most traders I have talked to like to play butterfly with call options and not with put options. I think it has more to do with human psychology than anything technical. We love to buy call options more than the put options, don’t we? I do not know the reason why, but I think we perceive markets going up more rather than down.

The fact is, it does not matter what option you are choosing to play a butterfly with, the risk reward will remain the same. Whether you trade a long put butterfly, or a long call butterfly – the risk and reward will be same.

When to Trade A Long Put Butterfly?

You should trade a long put butterfly when you have the view that the markets will consolidate for a few days. If Nifty does not move much and remains range-bound, you should be able to profit.

Risk: Is Limited
Reward: Is also Limited

Long Put Butterfly Trade:

1. Sell 2 ATM Put Options
2. Buy 1 Immediate ITM Put Option
3. Buy 1 Immediate OTM Put Option

Let me take a live example of market closing rates on Monday October 20, 2014.

India VIX is at: 14.19 (It is down 13.48% from previous close. But since you will be both a buyer and seller of nearby options – INDIA VIX does not have a big role to play in your trade. So while trading long put butterfly, your view is important – volatility cannot do anything to help or harm you. However if the volatility is high, it will help you to get good credit while selling ATM options, unfortunately you end up paying more for the other options bought. Vice versa when the volatility is low. As you can see volatility does not have a big role to play here. Though high volatility may bring in slightly more profits not significant.

Spot Nifty: 7879.40 (We will treat 7900 as ATM strike) Lets get the last trading prices of current month options expiring in 10 days from today:

1. Sell 2 7900 Put Options: 67.10
2. Buy 1 8000 Put Option (In The Money): 127.80
3. Buy 1 7800 Put Option (Out of The Money): 33.05

Calculations:

Sell 2 7900 Put Options: 67.10 * 50 * 2 = 6710 (Credit)
Buy 1 8000 Put Option: 127.80 * 50 = 6390 (Debit)
Buy 1 7800 Put Option: 33.05 * 50 = 1652.5 (Debit)

Total Investment: 6710 – 6390 – 1652.5 = Rs. (-)1332.50 (Debit)

Margin Blocked (as per NSE guidelines): 25,000 per option sold, 0 for OTM options bought, full money blocked for ITM option bought:

25000 + 25000 + 0 + 6390 = Rs. 56390.00 (Approx)

Now assuming that the trade finished perfect. One the expiry day Nifty is at 7900:

Sell 2 7900 Put Options: Expires worthless. The trader keeps the credit of Rs. 6710.00

Buy 1 8000 Put Option: is now at 100. Loss 100 – 127.80 = -27.8 * 50 = -1390

Buy 1 7800 Put Option: Expires worthless. The trader losses the money paid to buy this option: -1652.50

Total profit: 6710 -1390 -1652.50 = Rs. 3667.50

Return on Investment: (3667.50/56390) * 100 = 6.50% in just 10 days.

Isn’t this a great trade if it works well?

But I do not recommend trading butterfly. Lets see the reasons why?

Supposing the trade did not work well and Nifty is just 100 points up (at 8000) on the expiry day:

Sell 2 7900 Put Options: Expires worthless. The trader keeps the credit of Rs. 6710.00

Buy 1 8000 Put Option: Expires worthless. Loss 100% of the cash to buy it: -6390

Buy 1 7800 Put Option: Expires worthless. The trader losses the money paid to buy this option too: -1652.50

Loss: 6710 – 6390 – 1652.50 = Rs. -1332.50 (The initial cash invested to trade this strategy)

The results will be same if Nifty is anywhere above 8000.

Lets look at the lower end. Nifty is just 100 points below 7900 or 7800 on the expiry day:

Sell 2 7900 Put Options: The 7900 option is at 100. Original value: 67.10. Loss 67.10 – 100 = -32.9 * 50 * 2 = -3290.00

Buy 1 8000 Put Option: Is now at 200. Profit: 200 – 127.80 = 72.2 * 50 = 3610

Buy 1 7800 Put Option: Expires worthless. The trader losses the money paid to buy this option too: -1652.50

Loss: -3290 + 3610 – 1652.50 = Rs. -1332.5 (The initial cash invested to trade this strategy)

It does not matter where is Nifty below 7800, the trader will suffer the same limited loss.

Lets calculate the loss percentage.

NOTE: This is also very important from trading point of view. As a conservative trader, I want to know before trading what is my Max loss in the trade. If I am not comfortable losing that much money I do not trade or reduce the lot size.

(-1332.5 / 56390.00) * 100 = -2.36%.

Yes the risk-reward of -2.36% to 6.50% in just 10 days looks very attractive and traders get attracted to the Long Put Butterfly or the Long Call Butterfly, due to this. But unfortunately most butterfly trades are losers. WHY? Because a 100 point movement can come anytime – even in 1 hour. How can you avoid that?

The trade looks good when initiated, but as time passes and Nifty starts to move in any direction – you will start feeling the pinch. Traders are left hoping and praying Nifty does not move. With this trade what you are essentially hoping is that from the second you put the trade, Nifty should remain in a very tight range. How many times will that be possible? Possibly 1 in 10 times.

Is there any adjustment strategy to the Long Put Butterfly?

No. The only thing you can try doing is to move your trade where Nifty goes, you want your sold strike to remain ATM. Frankly, every time you do this, you will lose money. By the time the expiry day arrives, you may have lost so much money that even if Nifty expires at your new sold strike position – the profits will not be enough to cover the losses done while adjusting. The whole experience will also frustrate you. As you may have done a number of adjustments and even after Nifty finishing where you wanted, the trade was a loser. Your broker was a winner though. 😉

The only way out is to trade this when the expiry is very near – like today – expiry is just 10 days away. Or trade even just 5 days away as the risk and reward is limited. However after that your only job is to hope that Nifty finishes where you want it to be on the expiry day – adjustments if any will cost you. Close the trade at 3.15 pm on expiry day. If you made a profit, consider yourself lucky – the trade had nothing to do with your profits. 🙂 Do you really want to trade this now?

This is the major reason why I discourage any trade that requires any kind of prediction. If you want to predict – predict for the worst outcome – you will become a better trader. I encourage you to try non-directional trades where almost no prediction is required.

Today is Diwali 2014. Here is wishing you all a Very Happy Diwali and great trades in the future.

I hear a lot of stories on how people lose money trading options. Most of them are not worth sharing. But this one stands out and I thought I should share this with visitors of my website who are looking to buy that option for a big home-run.

Update: 40 lakhs looks too small compared to this aggressive trader who lost more than Rs. 2 crores trading options aggressively. You must read about this trader too.

I do not think anyone in this world exists who has had a real home-run buying options (I mean made so much money buying options that they can now stop trading and live a comfortable life). Yes, you will find people who are doing well trading options – but they have a solid strategy that they master.

Note: I have also written earlier why buying options will not make money over a long time. This post gives you a real example how things can go horribly wrong.

Recently I received an email from one one person from a small town in West Bengal, India. I have got his permission to share his email with this website visitors. If you are also looking for that home-run buying options you should read it:

Hello Mr. Dilip,

I stumbled upon your website from Google after searching for a low-risk options trading strategy for Nifty. And today, the whole day I was reading almost all stuff at your site. I can remember, while reading at your Yes Bank and IDBI trade, I myself and my uncle made an options purchase from a veteran trader’s call in a stock trading forum, that gradually worth around 6 lakhs went to zero, and we ended up loosing everything.

That was start few years back and by now I have donated most of the money to the market what I have earned from my now dysfunctional business – around 40 lakhs or more. Tried everything, Commodity, Futures, Pair-Trading. Less tried are Currency derivatives and Equity.

Now I can’t take any unknown risk. And at this moment, I am at a very crucial point of my life. I am 41 years old, have wife and two little kids. I have no job except some 15 lakhs FD that earns some interest, and around a 5 lakh trading A/c.

Right at this moment, I can’t have the luxury of loosing money any more. I know, whatever I have given to the market is just my mistake, I accept all the responsibility, because always I have placed large bets even after reading Van Tharp position sizing book. How silly I am – I always wanted to have that big home-run.

And I burnt my hand always.

Now I think it is the time to get all those money back with a constant rate. I do not want very high return, but a 5-6% per month steady return as per your strategy in any market condition and peace of mind will just do. Because, right at this moment, I am just looking to take care of my family, at least 30K per month is enough for me at this time.

Can you please help me?

Regards,
Name withheld

Isn’t this sad to read? Not only he lost lots of money, but he also lost a lot of time. Money can come back, time will never. A person who was once making 2 Lakhs per month is now dying to make 30 thousand per month. I know its painful, but greed took all money from this investor.

I asked him to first look for a job as a high priority. He has two kids and he is responsible for their well being and giving them good education. My course can of course come later.

I also told him if it was possible then he should again start that old business. He must be good at it that is why he was making so much money. That business was making him more than 2 lakhs per month, I see no reason why it cannot make 25% of that now.

Even a job paying 15-20k per month should be fine for him now. It will help him to meet the monthly expenses of his family. This will also ensure that he need not touch his bank fixed deposits.

If you are reading this and are in a similar situation, please take up a job as soon as possible. Then learn trading and start trading in small quantity. Once you are confident, only then increase your trading size. Do not fall for greed.

When I asked him why he did not stop at around 10 lakhs loss which is still bearable, he gave me a good reply.

Dilip, if you study Quantum physics, you will find that everything is vibration. When I earned that money month after month, it was my disbelief or low vibration about money in my Subconscious Mind that self-sabotaged me and took away all the money. At that stage, when I was earning even more than 2 lakhs per month in some months, my Subconscious Mind definitely rejected that idea or vibe – thought it was artificial or inflated and found a way to destroy that wealth and led me to join Stock market.

During six-month study period of your course, I must raise my vibration to a much higher level and must match those frequency at which that amount of money will manifest; otherwise nothing is going to happen for sure.

You may not believe, but it is true, if you wish, you can read a book called “Psycho-Cybernetics” by Maxwell Maltz.

http://en.wikipedia.org/wiki/Psycho-Cybernetics

OK may be this is true, but I still feel one should put a stop to ones greed.

Lets assume that he actually made 80 lakhs by buying options using the 40 lakhs money he had in his trading account. Do you think he would have stopped there? NO. His next target would be 160 lakhs and so on. Do you think he would have been successful every time he traded? Eventually he would have bought some option that would have expired worthless. He would still say the same story. It does not matter if he made 80 lakhs from 40 lakhs then lost it all – what matters is that he lost and he lost due to greed.

So, what are the lessons we can learn from this story?

1. Greed is bad in trading. Stick to your profit target or loss. Do not hesitate to take a stop loss if trade is not going in your favor. Also when the required profit target is met, do not hesitate to book profits. Waiting for more profits may take the trade back to losses. Similarly waiting for the trade to turn in your favor is futile – you will incur more losses.

2. Do not force yourself to trade. Just because you think an option will double in few days time does not mean you are correct. If you are not comfortable, just do not trade. Ask yourself before placing any trade – are you taking a big gamble? If the answer is yes – you are getting greedy and you should not trade.

3. If you want to speculate – then speculate for the worst possible outcome from a trade. Keep a plan ready when it actually happens. Stop loss or adjustments – keep it in writing.

4. Discipline is important. If you have only 10 lakhs to trade and have decided not to bring in any more money to your trading account, then do not bring any new money into it. That money may turn to one crore or zero. At least you will have the rest of the money to live your life and support your family. Read this to know how to manage your financial portfolio.

5. Money made from the stock markets is not free money. It comes with education, stress, strategy, planning and discipline. Do not disrespect this money. Psycho-Cybernetics or whatever is only an excuse – your money will not come back neither the time. If you are reaching your goals, slowly start withdrawing the profits from the trading account and put it in a liquid fund or bank FDs. Life has a limit – what makes you think that you will be trading forever and making money?

6. Share your profits and losses with your spouse. They have a different psychology and mindset than yours. I am sure he did not share his losses with his wife. Had he done that she would have asked hom to stop and concentrate in his business rather than the stock markets.

7. Always hedge your positions. That way even if you lose in one trade, the other trade will bring in some profits. If you are playing naked options, and if there is a huge gap up/down and your position is not hedged, you may lose massive money. You may never even get to take the stop loss because you will have lost it all.

8. Get some trading education. If you feel you are comfortable buying stocks – learn which stocks to buy and when. If you love future trading – know how to hedge them in the best possible way. If you love options trading – learn how they work, what are the best strategies that work.

9. Give the biggest priority to the source that generates the most income. If its your job – take it seriously. Work hard. Try to increase your salary. If its some business then read more about it. Master the craft. Become the best businessman in that field. If its stock market trading then do not stop learning even if you are the best in the world. Target small profits every month and be satisfied with them. Small profits will add up a huge amount in few years. Do not try for a home-run. It will slowly bleed you to financial bankruptcy and believe me you will never know. You will only realize when you will have already lost a substantial amount.

10. Greed and Fear both are your biggest enemies in trading. I am sure many of you are good traders but just do not trade because of the fear of losing. Interestingly even those who fear lose money. If you are good in trading but fear increasing your lot size then over a period of time you will end up losing even more than what greedy traders lose. Unfortunately you will never know. Don’t we hear stories from our friends/relatives who say, “Alas, if I had invested in so and so stock at that time I would have been a crorepati by now”. Well that was fear. Can you see one lost investment here is equal to one crore?

With this article if I am able to help you understand that Greed is not good neither is fear then I feel I have done my job. Learn to balance them and I bet you will become a good trader.

All the Best!