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Description and use

Short Put Butterfly is similar to Short Call Butterfly, but instead of Call positions, the strategy consists of Put options. Short Put Butterfly is the opposite of Long Put Butterfly strategy. Despite the net credit, it is not popular, because its return is smaller than a Straddle’s or a Strangle’s return. To establish the position, the trader needs to have a lower strike Short Put, two middle ATM Long Puts, and a higher strike ITM Short Put in the portfolio. The investor can profit from shares with large price fluctuations. The disadvantage of this strategy is the limited profit and the maximum loss when share prices are moving in a range. The direction of the market is neutral. The investor speculates on shares with high volatility. The potential profit has an upper limit. The expiration should be at least three months.

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

Opening the position

Short Put Butterfly Option Positions

Short Put Butterfly Option Positions

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

Steps

Entry:

  • Look for shares showing pennant or similar shapes on charts.

Exit:

  • The position can be closed only before expiration.

Basic characteristics

Maximum loss: Difference between consecutive strike prices - Net credit.

Maximum profit: Net Credit.

Time decay: Time usually has a negative effect on the value. However, when the position is making profit, time can have a positive effect as well.

Lower breakeven point: Lower strike price + Net Credit.

Upper breakeven point: Higher strike price - Net Credit.

Advantages and disadvantages

Advantages:

  • Limited loss.
  • High possible return when share prices moving explosively.

Disadvantages:

  • Profit can be increased only if the strike prices are farther from each other.
  • Potentially higher profit is only possible close to expiration.
  • The potential loss is much larger than the potential profit.

Closing the position

Closing the position:

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

Mitigation of losses:

  • Close the position the above-mentioned way.

Example

Short Put Butterfly strategy example

Short Put Butterfly strategy example

ABCD is traded for $50.00 on 17.05.2017. The investor sells a Short Put option which has a strike price of $45.00, expires in August 2017. and costs $2.57 (premium). Then, he buys 2 Long Put options which have a strike price of $50.00, expire in August 2017. and cost $4.83 (premium). Finally, sells another Short Put option which has a strike price of $55.00, expires in August 2017. and costs $7.85 (premium).

Price of the underlying (share price): S= $50.00
Premium (Short Put 1): SP1= $2.57
Premium (Long Puts): LP= $4.83
Premium (Short Put 2): SP2= $7.85
Strike price (Short Put 1): KS1= $45.00
Strike price (Long Puts): KL= $50.00
Strike price (Short Put 2): KS2= $55.00
Net credit: NCr
Maximum loss: R
Maximum profit: Pr
Lower breakeven point: LBEP
Upper breakeven point: UBEP

Net credit: NCr = (SP1 + SP2) - 2 * LP
Maximum loss (risk): R = (KS2 - KL) - NCr or R = (KL - KS1) - NCr
Maximum profit: Pr = NCr
Lower breakeven point: LBEP = KS1 + NCr
Upper breakeven point: UBEP = KS2 – NCr

NCr = $0.76
R = $4.24
Pr = $0.76
LBEP = $45.76
UBEP = $54.24