What is a Short Put Butterfly Options Strategy?
The Short Put Butterfly is a market-neutral strategy. Market neutral means the price of a stock is about to move in either an upward or downward direction after consolidation. This strategy consists of three put option strike prices of the same underlying stock and contract expiration date.
With this strategy, the goal is to profit from a sharp downward or upward movement in underlying stock’s price by selling one put option with higher strike price to capture profit from the upward movement of price as well as selling a put option with lower strike price to profit from the downward price movement. The two strike prices should be at the money to limit the risk and save margin money.
What is a Short Put Butterfly?
Short Put Butterfly is a three-legged options trading strategy. It is created by selling one Put option at a higher strike price, purchasing two middle strike price put options and selling another put option at a lower strike price of same expiry date and underlying stock.
Selling higher and lower strike price put options will allow profiting from upward and downward movement in the price of underlying stock. Buying the middle strike put options will reduce the risk.
Traders pay an amount for buying options, and the risk becomes limited to this amount paid. When selling an option, traders receive an amount, which is the limited profit amount.
When to Initiate Short Put Butterfly Strategy?
A Short Put Butterfly aims to profit from swift price changes in underlying stocks. This swift movement in price increases volatility. Now, what is volatility? Volatility is the price sensitivity in the underlying stock and its option contracts. An increase in volatility means higher option prices, and the opposite happens when it falls.
Low volatility in underlying stock prices is a favourable scenario for implementing this strategy. Trading a Short Put Butterfly needs patience and discipline. Traders should wait for stock prices to move or rise in volatility. As expiration approaches, any small change in price of the underlying stock can have a big impact on the price of the options. Thus, traders must be disciplined in taking partial profits and small losses before they become big.
How to Use the Strategy and Choosing Option Strike Prices?
Let’s see how a Short Put Butterfly strategy works by comparing strike prices.
These are the options price of stock ABC Ltd. at different strike prices:
|Strike Price||Options Price||Types of Options|
|17650||₹4||Out of the Money|
|17700||₹10||Out of the Money|
|17750||₹30||Out of the Money|
|17800||₹60||At the Money|
|17850||₹100||In the Money|
|17900||₹180||In the Money|
|17950||₹230||In the Money|
The stock of ABC Ltd. is currently priced at ₹17810 in the stock market. So, the nearest strike price is ₹17800, known as At the Money, because it is near the stock’s current price. Strike prices greater than ₹17800 are In the money strikes, as their value is greater than the current price of ₹17810. Options strike prices less than stock’s current price of ₹17810 are called out of the money options.
Now let’s see how to make a short put butterfly using the appropriate strike prices.
Strategy: Short Put Butterfly
Strike Price for the Trade:
Strike 1. 17850 PUT (ITM) we aim to profit from higher strike if stock’s price goes beyond ₹17850
Strike 2. 17800 PUT (ATM) ABC ltd. stock is trading near this value in the market.
Strike 3. 17750 PUT (OTM) The lower strike price will profit when stock goes below ₹17750.
- Sell one quantity of ITM PUT for ₹100 (+) (Get cash from the buyer after selling an option)
- Buy two quantity of ATM PUT for ₹60 (-) (Pay cash to the seller for buying an option)
- Sell one quantity of OTM PUT for ₹30 (+) (Receive cash for selling an option)
The positive and negative signs denote inflows and outflows of cash margin.
Calculation of net premium received and paid has been discussed below:
Total Premium Paid = ₹(60)*2 = ₹120
Total Premium Received = ₹(100 + 30 – 120) = ₹10
The Strategy gives a Net Credit of ₹10
Short Put Butterfly has limited profit if the stock’s price exceeds the higher strike price level of ₹17850 or goes below the lower strike price of ₹17750 till the expiry day.
On the other hand, if underlying stock trades between two breakeven points till expiration, the strategy will lead to a limited loss. The strategy will face maximum loss when stock closes near At the Money Strike on expiry day.
Profit probability of Short Put Butterfly strategy increases before any upcoming economic, corporate or political event. These strategies aim to gain from a sudden spike in volatility and become ineffective when volatility drops.
For example, option prices increase when volatility rises a week before election results. After the results, volatility drops along with a fall in option prices. In such scenarios, profits are booked as soon as possible, and in case of a loss, the strategy is closed before the expiration day.
The above diagram shows payoff structure of a Short Put Butterfly strategy where vertical axis shows amount of profit or loss, and horizontal axis for movement in underlying asset price.
Analysis of payoff diagram with respect to strike price selected has been discussed below:
- 17750 (OTM) PUT Strike Price
- 17800 (ATM) PUT Strike Price
- 17850 (ITM) PUT Strike Price
Here, the underlying asset is ABC Ltd stock.
- The strategy starts will give limited profit if stock price goes below the lower breakeven price on or before expiry.
- The loss will be limited to two breakeven point prices and a maximum of ₹17800 contract’s premium price
- Short Put Butterfly will give limited profits if the stock price rises above the upper breakeven price.
The calculation of breakeven points are as follows:
Lower Breakeven Point = ₹(17750 + Net Premium Received)
= ₹(17750 + 10)
Upper Breakeven Point = ₹(17850 – Net Premium Received)
= ₹(17850 – 10)
Maximum Profit = Net Premium Received*Lot Size
Maximum Loss = ₹(17750 – 17800 + Net Premium Received)*Lot Size
= ₹(17750 – 17800 + 10)*50
= ₹ -40 *50 = -(₹2000)
From the above outcome, we can see that Short put butterfly will profit up to ₹500 when ABC Ltd price goes below ₹17760 and above ₹17840 before expiration of options contract.
If ABC Ltd.’s price closes at 17800, the maximum loss would be ₹2000.
Short Put Butterfly makes maximum profit when the underlying stock’s price is above or lower than sold put option strike prices on expiration date. It happens when the underlying asset price is less volatile, but stock price moves outside the breakeven range as time passes.
Impact of Price Change in Short Put Butterfly
Delta measures the change in the profitability of a position. Buy Puts have a negative delta and sell puts have a positive delta. The delta of a short put butterfly is close to zero. Delta becomes positive when the underlying asset’s price rises above the upper strike price and negative when it closes below the lower strike price.
Change in Implied Volatility
Volatility measures the percentage change in underlying asset price and is important in option pricing. The option contract’s value rises along with volatility and the asset’s price and time to expiry remain unchanged. Vega measures the change in volatility. A short put butterfly has positive vega; this means that this strategy should be used when volatility is low.
Bought options make money, while short options lose. Similarly, when volatility falls, the opposite happens.
Impact of Time Till Expiration of Options Contract
Options lose value as time passes and starts depleting faster near expiration; this is measured by Theta. Bought options have negative theta, which means that the value declines with time. On the opposite, sold options gain from theta.
Short Put Butterfly has negative theta when the underlying asset’s price moves within range of upper and lower strike prices. But, when the underlying asset’s price moves outside the range of two bought options, the theta value becomes positive.
Advantages of Short Put Butterfly
- This is a credit strategy with no cash outflow when deploying.
- Maximum loss is defined.
- This strategy benefits from a rise in volatility.
Disadvantages of Short Put Butterfly
- This strategy has limited profit potential
- Risk-reward of this strategy is unfavourable as risk is higher than reward.
- Theta and time decay negatively affect the position when underlying price is range bound.
A short-put butterfly is a net credit strategy that results in cash inflow at the initiation. It benefits from the rise in volatility. Traders should initiate this strategy when option prices are low. This is a limited risk and reward strategy; however, risk to reward ratio is attractive.
Frequently Asked Questions
What are butterfly strategies in trading?
In a Butterfly strategy, three different options strike prices are chosen to trade – At the money strike, In the money strike and Out of money strikes in the quantity of 2:1:1.
When is the short put butterfly strategy used?
When the price of the underlying stock is trading in a range, and the volatility is low but is expected to increase, the price is forecasted to move sharply in a higher or lower direction. This is when the short put butterfly strategy can be used.
How much risk does the Short Put Butterfly strategy carry?
The risk is limited along with the profit. But the risk is comparatively higher than the profit. The risk-reward favours only in some situations, such as any disruptive event or announcement.