The long put butterfly spread is a limited profit, limited risk options trading strategy that is taken when the options trader thinks that the underlying security will not rise or fall much by expiration.
|Long Put Butterfly Construction|
|Buy 1 OTM Put|
Sell 2 ATM Puts
Buy 1 ITM Put
There are 3 striking prices involved in a long put butterfly spread and it is constructed by buying one lower striking put, writing two at-the-money puts and buying another higher striking put for a net debit.
Maximum gain for the long put butterfly is attained when the underlying stock price remains unchanged at expiration. At this price, only the highest striking put expires in the money.
The formula for calculating maximum profit is given below:
Maximum loss for the long put butterfly is limited to the initial debit taken to enter the trade plus commissions.
The formula for calculating maximum loss is given below:
There are 2 break-even points for the long put butterfly position. The breakeven points can be calculated using the following formulae.
Suppose XYZ stock is trading at $40 in June. An options trader executes a long put butterfly by buying a JUL 30 put for $100, writing two JUL 40 puts for $400 each and buying another JUL 50 put for $1100. The net debit taken to enter the trade is $400, which is also his maximum possible loss.
On expiration in July, XYZ stock is still trading at $40. The JUL 40 puts and the JUL 30 put expire worthless while the JUL 50 put still has an intrinsic value of $1000. Subtracting the initial debit of $400, the resulting profit is $600, which is also the maximum profit attainable.
Maximum loss results when the stock is trading below $30 or above $50. At $50, all the options expires worthless. Below $30, any "profit" from the two long puts will be neutralised by the "loss" from the two short puts. In both situations, the long put butterfly trader suffers maximum loss which is equal to the initial debit taken to enter the trade.
Commission charges can make a significant impact to overall profit or loss when implementing option spreads strategies. Their effect is even more pronounced for the long put butterfly as there are 4 legs involved in this trade compared to simpler strategies like the vertical spreads which have only 2 legs.
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The following strategies are similar to the long put butterfly in that they are also low volatility strategies that have limited profit potential and limited risk.
The converse strategy to the long butterfly is the short butterfly. Short butterfly spreads are used when high volatility is expected to push the stock price in either direction.
The long butterfly strategy can also be created using calls instead of puts and is known as a long call butterfly.
The long put butterfly spread belongs to a family of spreads called wingspreads whose members are named after a myriad of flying creatures.
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