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Short Put Butterfly Option Strategy Explained

Introduction

The short-put butterfly strategy is a market-neutral strategy. You can deploy it to earn profits when a stock’s price increases or falls beyond the highest and lowest strike prices. The strategy involves three puts with equidistant strike prices and the same expiration date.

What is a short-put butterfly strategy?

The short-put butterfly is a three-legged trading strategy. It involves selling an out-of-the-money (OTM) put option, buying two at-the-money (ATM) put options and selling another in-the-money (ITM) put option. It combines a bull put spread and a bear put spread. 

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The strategy aims to be neutral when it comes to market direction. But it benefits from the potential rise in volatility. Moreover, the risk and reward of the positions is predetermined and limited. 

The short-put butterfly is a net credit strategy. With a neutral direction, it has two breakeven points. The upper breakeven point is calculated by subtracting the net premium received from the upper strike price. The lower breakeven point is calculated by adding the net premium to the lower strike price. 

Due to two breakeven points, the strategy offers two ways to profit. When the underlying stock's price goes beyond either of the breakeven points, you can achieve the maximum profit. Such movement in price happens with a rise in volatility and rapid price changes. But as the strategy has a limited risk-to-reward ratio, you can earn profits only to the amount of option premium received. The profit is equal to the net premium received. 

Conversely, when volatility contracts and there is no price change or within the two breakeven points, you need to calculate the maximum potential loss, which is limited. 

Here’s the formula for calculating loss:

Lower strike - middle strike + net premium received

When you initiate this strategy, it is vital to note that the strike prices are equidistant from each other. This means the variation between the lower and middle strike and the middle and higher strike prices are the same. 

Illustration

Here’s a look at the three put options you will make to initiate the short-put butterfly options strategy. 

  • Short 1 ABC 110 at 200
  • Long 2 ABC 100 at 175
  • Short 3 ABC 90 at 175

Total premium paid = 175*2 = 350 (since you will be buying two units in the second step)

Total premium received = 200 + 175 = 375

Net premium received = 375 - 350 = 25

Initiating the strategy returns a net credit of Rs. 25 in this example. 

The strategy aims to capture an increase in implied volatility or movement in asset price. Since the shape is similar to a butterfly, the strategy is named the short-put butterfly option strategy

When can you initiate the short-put butterfly strategy?

The goal of a short-put butterfly is to gain from swift price changes of underlying assets. Volatility increases with swift changes in price. A rise in volatility leads to higher option prices, whereas a drop in volatility signals lower option prices. 

You can initiate the strategy when the volatility in underlying asset prices is low. But it requires patience and discipline. You must wait for stock prices to rise or move in volatility. When the expiry date is close, a minor movement in the underlying stock’s price can greatly impact the options' price. Thus, you must be disciplined in booking small losses and partial profits before making it big. 

Pros of the short-put butterfly

  • The strategy defines the maximum loss. 
  • The credit strategy has no cash outflow at the time of initiation.
  • It benefits from time decay and a rise in volatility. 

Cons of the short-put butterfly

  • There is limited profit potential. 
  • The impact of theta and time decay negatively affects the position when the underlying price is range-bound. 
  • The strategy’s risk-to-reward ratio is unfavourable as the chance of risk is more than the reward. 

Conclusion

The short-put butterfly options spread is a net credit strategy with no cash outflow during deployment. It benefits from a rise in volatility and time decay. You must initiate the strategy at the right time to reap gains. If you initiate it close to expiration to make the most of quick time decay, the time for implied volatility to show results is less. 

You might feel discouraged from implementing the strategy due to an unattractive risk-to-reward ratio. However, the payoff is similar to the Long Call Butterfly and the Long Iron Butterfly option strategy.

 

Related Articles: A Guide to Investing In Over The Counter Stocks | All You Need to Know About the Covered Put Strategy | Options Trading With Iron Condor Strategy | Iron Butterfly Vs Iron Condor Trading Strategies

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