Question

Q3. You are (almost) convinced that the aggregate market is going to exhibit low volatilities over the next 3 months. You are considering a bet on the low volatility. On the one hand, you want to establish a trade to take advantage of low volatilities. On the other hand, you don’t want a strategy that will result in large losses should the volatility rea3lly go up over the next few months. What would be a good options strategy in this case? Briefly discuss when you would make profits and in what situations would you incur losses? You can look up SPY and index option quotes online; use these numbers to explain your strategy.

Answer 1

We will use a short iron butterfly strategy

A short iron butterfly option strategy will attain maximum profit when the price of the underlying asset at expiration is equal to the strike price at which the call and put options are sold. The trader will then receive the net credit of entering the trade when the options all expire worthless.

A short iron butterfly option strategy consists of the following options:

• Long one out-of-the-money put: strike price of X − a
• Short one at-the-money put: strike price of X
• Short one at-the-money call: strike price of X
• Long one out-of-the-money call: strike price of X + a

For eg:

Strike	Option	Buy/Sell	Option Price
90	Put	Buy	2.5
100	Put	Sell	5
100	Call	Sell	5
110	call	Buy	2.5

Net Inflow form this strategy

Strike	Option	Buy/Sell	Cash Flow
90	Put	Buy	-2.5
100	Put	Sell	5
100	Call	Sell	5
110	call	Buy	-2.5
			10

PAYOFF and profit

Stock Price	Put	Put	Call	Call	Total	Premium collected	Profit
80	10	-20	0	0	-10	5	-5
85	5	-15	0	0	-10	5	-5
90	0	-10	0	0	-10	5	-5
95	0	-5	0	0	-5	5	0
100	0	0	0	0	0	5	5
105	0	0	-5	0	-5	5	0
110	0	0	-10	0	-10	5	-5
115	0	0	-15	5	-10	5	-5
120	0	0	-20	10	-10	5	-5

As shown in the following diagram

If the price of the stock is between 95-105 we will make profit else we will make loss