While investing in the stock market can be extremely luring, it is an investment that needs to be carefully made. After all, you expect good returns from it. To put it simply, investing in the stock market can be a thrilling but complex journey.
When you navigate this financial landscape, you are likely to come across several strategies and terms that may be beyond your understanding at first. One such strategy that often intrigues investors is none other than the butterfly strategy. There’s another one in the form of options theta. Through this detailed guide, we shall shed light on these terms and explore how they can be fruitfully utilized by investors, especially novice individuals.
Understanding Options
Before straightaway turning to these terms, it is pivotal to have a basic understanding of options. Well, options are financial instruments that provide investors with the authority to buy or sell an underlying asset at a predetermined price within a specified timeframe. Additionally, there are fundamentally two types of options, namely call options and put options. Now, let’s talk about them individually.
- Call Options
These provide the holder with the right to buy the underlying asset at a specified price before or at the expiration price.
- Put Options
These provide the holder with the authority to sell the underlying asset at a specified price before or at the expiration price.
Now, instead of digressing from the main topic, let’s comprehend the concept of options theta
Options Theta
When it comes to options trading, the role of options theta cannot be overlooked. Also termed time decay, it demonstrates the rate at which the value of an option dwindles with time, especially as the expiration date approaches. In pretty simple terms, options theta reflects the impact of time on the price of an option.
You must now be wondering why, in actuality, does time decay matter? Well, it is important to note here that options have a limited lifespan. Hence, as their expiration date approaches, their value tends to fall drastically. This is when the role of options theta comes into play and can help quantify this erosion of value over time. Investors must diligently understand the concept of options theta as it directly affects how much money they can make with options.
Butterfly Strategy
Moving on to the next part, the Butterfly Strategy. To your knowledge, it is an options trading strategy that entails three strike prices. Butterfly spreads are further divided into two categories in the form of the call butterfly spread and the put butterfly spread.
Call Butterfly Spread
- Buy Call Option
In this option, the investor buys a one-call option with a lower strike price.
- Sell Two Call Options
As the name indicates, the investor sells two call options with a middle strike price.
- Buy Another Call Option
The investor buys one more call option, and that too at a higher strike price.
One of the fundamental purposes of implementing the Butterfly Strategy is to create a position where the potential profit is maximized even if the underlying asset closes at the middle strike price at expiration. The ineffable side of this strategy is that it benefits from low volatility and minimal price movement in the underlying asset.
If you still have any doubts related to the Butterfly Strategy, the following example is likely to give you additional clarity. Keep reading!
Assume you wish to invest in the stock XYZ, which is currently trading at $100 per share. Further, you decide to implement a call-butterfly spread with the following options:
- Buy one call option with a strike price of $95
- Sell two call options with a strike price of $100
- Buy one more call option with a strike price of $105
Based on the above assumptions, what will be the potential outcomes at expiration? Let’s understand!
- If XYZ closes at $100, the two call options expire worthless. That means the investor will be able to draw profits from the difference between the long-call options.
- Similarly, if XYZ closes above $105 or below $95, the investor in such a case will have to suffer a loss. This stands to reason: the long call options lose value and cannot compensate for the premiums received from the two short call options.
Put Butterfly Spread
When it comes to the put butterfly spread, it fundamentally focuses on the underlying asset to close at the middle strike price during expiration for maximum profit. The strategy is hailed to work amazing well in low-volatility scenarios.
Final words
By reaping the benefits of the Butterfly Strategy and having an understanding of options theta, investors draw a roadmap for themselves to easily navigate the options market. For beginners, these strategies might be difficult to understand, but with the aid of professionals' help, things can become more accessible to them. The experts at My Options Edge are available around the corner to assist you.
