Butterfly Spread with Puts Option Strategy

 

A long butterfly spread with puts is an advanced options strategy that consists of three legs and four total options. The trade involves buying one put at strike price A, selling two puts and strike price B and then buying one put at strike price C. The setup is what would happen if an investor combines the end of a long put spread and the start of a short put spread, joining them at strike price B.

A trader who opens this trade is betting that the stock will pin or come close to pinning at strike price B. If the stock does pin at the short strikes then the investor would bank the profits from option C, while options B and A expire worthless.

This strategy has a low entry cost, which means reduced risk if things take a turn for the worse, but it can be challenging to lock down that pinning strike. The long butterfly spread with puts is good to use in low volatile markets, where the price has a high probability of pinning. However, it can also be a good choice in unpredictable markets due to its limited loss, but traders should keep a close eye on the trade and close it out once the stock moves to the short strikes.

Profit/Loss



The maximum profit is calculated by taking the difference between the higher strike price and the middle strike price, then subtracting the cost of the trade. For example, if the distance between point C and B was $5 and the trade cost $0.70, then the max profit would be $4.30. The maximum loss would the cost of the trade, so with the same example, the maximum loss would be $0.70.

Breakeven

There are two breakeven points. The upper breakeven point would be calculated by taking the highest strike price (point C) and subtracting the cost of the trade. So, if point C was a 110-strike price option, and the trade cost $0.70, the lower breakeven would be $109.30.

The lower breakeven point would be calculated by taking the lowest strike price (point A) and adding the net debit. So, if the point A strike price was equal to $100 and the cost of the trade was $0.70, then our lower breakeven would be $100.70.

Conclusion

The lower a trader sets the strike prices, the more bearish a butterfly spread with puts becomes, while at the same time, reducing the cost of the trade. However, the lower the strike prices are set, the lower the probability of success.

This type of spread is sensitive to changes in implied volatility. The net price of the spread drops when implied volatility rises and the price increases when implied volatility falls, meaning it has an inverse relationship to implied volatility changes. The trader who executes this trade wants a drop to implied volatility.

The long butterfly spread with puts is not a strategy for a beginner, it’s recommended for experienced options traders.


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