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Description and use

Modified Put Butterfly is similar to Long Put Butterfly, but the difference between the strike of the middle Call and the higher Long Call is smaller than the difference between the strike of the lower Call and the other middle Call. This strategy is very similar to the Modified Call Butterfly. The profit is maximised when the share price closes close to the middle components’ strike price. This strategy requires the investor to pay close attention to details. To establish the position, the trader needs to have a lower strike Long Put, two middle ATM Short Puts, and higher strike OTM Long Put in the portfolio. The investor can profit from increasing share prices or the share prices moving within given limits. Despite the attractive risk/profit ratio, the maximum profit is limited. The direction of the market is neutral or moderately increasing. The expected profit is relatively high, given the low costs. The duration of the investment is one month or less.

  • Type: Neutral, Bullish
  • Transaction type: Credit
  • Maximum profit: Limited
  • Maximum loss: Limited
  • Strategy: Neutral strategy

Opening the position

Modified Put Butterfly Option Positions

Modified Put Butterfly Option Positions

  • Buy a lower strike (OTM) Put option.
  • Sell two middle (ATM) Put options.
  • Buy a higher strike (ITM) Put option.
  • All components must have the same expiration and only Put options are used. The difference between consecutive strike prices must be equal.

Steps

Entry:

  • Make sure the share prices are moving within certain limits.

Exit:

  • The position can be closed only before maturity.

Basic characteristics

Maximum loss: (Middle strike price – Lower strike price) - (Higher strike price - Middle strike prices) - Net Credit.

Maximum profit: Higher strike price - Lower strike price + Net debit.

Time decay: Time decay has a positive effect on the value when the position is profitable, and a negative effect when the position is lossmaking.

Breakeven point: Low strike price + Maximum loss.

Advantages and disadvantages

Advantages:

  • The investor can profit from share prices moving within given limits.
  • Low costs.
  • Relatively high risk/profit ratio.

Disadvantages:

  • Potentially higher profit is only possible close to expiration.
  • Limited profit.

Closing the position

Closing the position:

  • Buy back the Short Puts and sell the Long Puts.

Mitigation of losses:

  • Close the position the above-mentioned way.

Example

Modified Put Butterfly strategy example

Modified Put Butterfly strategy example

ABCD is traded for $50.00 on 17. 05. 2017. The investor buys a Long Put option which has a strike price of $45.00, expires in June 2017. and costs $0.98 (premium). Then sells two Short Put options which have a strike price of $55.00, expire in June 2. and cost $6.12 (premium). Finally, he buys a Long Put option which has a strike price of $60.00, expires in June 2017. and costs $10.28 (premium).

Price of the underlying (share price): S= $50.00
Premium (Long Put 1): LP1= $0.98
Premium (Short Puts): SP= $6.12
Premium (Long Put 2): LP2= $10.28
Strike price (Long Put 1): KL1= $45.00
Strike price (Short Puts): KS= $55.00
Strike price (Long Put 2): KL2= $60.00
Net Credit: NCr
Maximum loss: R
Maximum profit: Pr
Temporary risk/profit: int
Breakeven point: BEP

Net Credit: NCr = 2 * SP - (LP1 + LP2)
Maximum loss (risk): R = (KS - KL1) - (KL2 - KS) - NCr
Maximum profit: Pr = KL2 - KS + NCr
Temporary risk/profit: int = NCr
Breakeven point: LBEP = KL1 + R

NCr = $0.98
R = $4.02
Pr = $5.98
int = $0.98
BEP = $49.02