The short put butterfly is a neutral strategy like the long put butterfly but bullish on volatility. It is a limited profit, limited risk options strategy. There are 3 striking prices involved in a short put butterfly and it can be constructed by writing one lower striking out-of-the-money put, buying two at-the-money puts and writing another higher striking in-the-money put, giving the options trader a net credit to put on the trade.
|Short Put Butterfly Construction|
|Sell 1 ITM Put|
Buy 2 ATM Puts
Sell 1 OTM Put
Maximum profit is attained for the short put butterfly when the underlying stock price rally pass the higher strike price or drops below the lower strike price at expiration.
If the stock ends up at the higher striking price, all the put options expire worthless and the short put butterfly trader keeps the initial credit taken when entering the trade.
If, instead, the stock price at expiry is equal to the lower strike price, the lower striking put option expires worthless while the "profits" of the remaining long put is canceled out by the "loss" incurred from shorting the higher strike put. So the maximum profit is still only the initial credit taken.
The formula for calculating maximum profit is given below:
Maximum loss for the short put butterfly is incurred when the price of the underlying asset remains unchanged at expiration. At this price, only the higher striking put which was shorted expires in-the-money. The trader will have to buy back that put option at its intrinsic value to exit the trade.
The formula for calculating maximum loss is given below:
There are 2 break-even points for the short 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 short put butterfly by writing a JUL 30 put for $100, buying two JUL 40 puts for $400 each and writing another JUL 50 put for $1100. The net credit taken to enter the position is $400, which is also his maximum possible profit.
On expiration in July, XYZ stock has dropped to $30. All the options expire worthless and the short put butterfly trader gets to keep the entire initial credit taken of $400 as profit. This is also the maximum profit attainable and is also obtained even if the stock had instead rallied to $50 or beyond.
On the downside, should the stock price remains at $40 at expiration, maximum loss will be incurred. At this price, all except the higher striking put expires worthless. The higher striking put sold short would have a value of $1000 and needs to be bought back to close the trade. Subtracting the initial credit of $400 taken, the net loss (maximum) is equal to $600.
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 short 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 short put butterfly in that they are also high volatility strategies that have limited profit potential and limited risk.
The converse strategy to the short put butterfly is the long put butterfly. Long butterfly spreads are used when one perceives the volatility of the price of the underlying stock to be low.
The short butterfly can also be created using calls instead of puts and is known as a short call butterfly.
The short 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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