Short Put Butterfly Explained

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Butterfly Spread

What Is a Butterfly Spread?

A butterfly spread is an options strategy combining bull and bear spreads, with a fixed risk and capped profit. These spreads, involving either four calls or four puts are intended as a market-neutral strategy and pay off the most if the underlying does not move prior to option expiration.

Key Takeaways

  • There are multiple butterfly spreads, all using four options.
  • All butterfly spreads use three different strike prices.
  • The upper and lower strike prices are equal distance from the middle, or at-the-money, strike price.
  • Each type of butterfly has a maximum profit and a maximum loss.

Understanding Butterflies

Butterfly spreads use four option contracts with the same expiration but three different strike prices. A higher strike price, an at-the-money strike price, and a lower strike price. The options with the higher and lower strike prices are the same distance from the at-the-money options. If the at-the-money options have a strike price of $60, the upper and lower options should have strike prices equal dollar amounts above and below $60. At $55 and $65, for example, as these strikes are both $5 away from $60.

Puts or calls can be used for a butterfly spread. Combining the options in various ways will create different types of butterfly spreads, each designed to either profit from volatility or low volatility.

Long Call Butterfly

The long butterfly call spread is created by buying one in-the-money call option with a low strike price, writing two at-the-money call options, and buying one out-of-the-money call option with a higher strike price. Net debt is created when entering the trade.

The maximum profit is achieved if the price of the underlying at expiration is the same as the written calls. The max profit is equal to the strike of the written option, less the strike of the lower call, premiums, and commissions paid. The maximum loss is the initial cost of the premiums paid, plus commissions.

Short Call Butterfly

The short butterfly spread is created by selling one in-the-money call option with a lower strike price, buying two at-the-money call options, and selling an out-of-the-money call option at a higher strike price. A net credit is created when entering the position. This position maximizes its profit if the price of the underlying is above or the upper strike or below the lower strike at expiry.

The maximum profit is equal to the initial premium received, less the price of commissions. The maximum loss is the strike price of the bought call minus the lower strike price, less the premiums received.

Long Put Butterfly

The long put butterfly spread is created by buying one put with a lower strike price, selling two at-the-money puts, and buying a put with a higher strike price. Net debt is created when entering the position. Like the long call butterfly, this position has a maximum profit when the underlying stays at the strike price of the middle options.

The maximum profit is equal to the higher strike price minus the strike of the sold put, less the premium paid. The maximum loss of the trade is limited to the initial premiums and commissions paid.

Short Put Butterfly

The short put butterfly spread is created by writing one out-of-the-money put option with a low strike price, buying two at-the-money puts, and writing an in-the-money put option at a higher strike price. This strategy realizes its maximum profit if the price of the underlying is above the upper strike or below the lower strike price at expiration.

The maximum profit for the strategy is the premiums received. The maximum loss is the higher strike price minus the strike of the bought put, less the premiums received.

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Iron Butterfly

The iron butterfly spread is created by buying an out-of-the-money put option with a lower strike price, writing an at-the-money put option, writing an at-the-money call option, and buying an out-of-the-money call option with a higher strike price. The result is a trade with a net credit that’s best suited for lower volatility scenarios. The maximum profit occurs if the underlying stays at the middle strike price.

The maximum profit is the premiums received. The maximum loss is the strike price of the bought call minus the strike price of the written call, less the premiums received.

Reverse Iron Butterfly

The reverse iron butterfly spread is created by writing an out-of-the-money put at a lower strike price, buying an at-the-money put, buying an at-the-money call, and writing an out-of-the-money call at a higher strike price. This creates a net debit trade that’s best suited for high-volatility scenarios. Maximum profit occurs when the price of the underlying moves above or below the upper or lower strike prices.

The strategy’s risk is limited to the premium paid to attain the position. The maximum profit is the strike price of the written call minus the strike of the bought call, less the premiums paid.

Example of a Long Call Butterfly

An investor believes that Verizon stock, currently trading at $60 will not move significantly over the next several months. They choose to implement a long call butterfly spread to potentially profit if the price stays where it is.

An investor writes two call options on Verizon at a strike price of $60, and also buys two additional calls at $55 and $65.

In this scenario, an investor would make the maximum profit if Verizon stock is priced at $60 at expiration. If Verizon is below $55 at expiration, or above $65, the investor would realize their maximum loss, which would be the cost of buying the two wing call options (the higher and lower strike) reduced by the proceeds of selling the two middle strike options.

If the underlying asset is priced between $55 and $65, a loss or profit may occur. The amount of premium paid to enter the position is key. Assume that it costs $2.50 to enter the position. Based on that, if Verizon is priced anywhere below $60 minus $2.50, the position would experience a loss. The same holds true if the underlying asset were priced at $60 plus $2.50 at expiration. In this scenario, the position would profit if the underlying asset is priced anywhere between $57.50 and $62.50 at expiration.

This scenario does not include the cost of commissions, which can add up when trading multiple options.

Short Put

What is a Short Put

A short put refers to when a trader opens an options trade by selling or writing a put option. The trader who buys the put option is long that option, and the trader who wrote that option is short. The writer (short) of the put option receives the premium (option cost), and the profit on the trade is limited to that premium.

Basics of the Short Put

A short put is also known as an uncovered put or a naked put. If an investor writes a put option, that investor is obligated to purchase shares of the underlying stock if the put option buyer exercises the option. The short put holder could also face a substantial loss prior to the buyer exercising, or the option expiring, if the price of the underlying falls below the strike price of the short put option.

Short Put Mechanics

A short put occurs if a trade is opened by selling a put. For this action, the writer (seller) receives a premium for writing an option. The writer’s profit on the option is limited to that premium received.

Initiating an option trade to open a position by selling a put is different than buying an option and then selling it. In the latter, the sell order is used to close a position and lock in a profit or loss. In the former, the sell (writing) is opening the put position.

If a trader initiates a short put, they likely believe the price of the underlying will stay above the strike price of the written put. If the price of the underlying stays above the strike price of the put option, the option will expire worthless and the writer gets to keep the premium. If the price of the underlying falls below the strike price, the writer faces potential losses.

Some traders use a short put to buy the underlying security. For example, assume you want to buy a stock at $25, but it currently trades at $27. Selling a put option with a strike of $25 means if the price falls below $25 you will be required to buy that stock at $25, which you wanted to do anyway. The benefit is that you received a premium for writing the option. If you received a $1 premium for writing the option, then you have effectively reduced your purchase price to $24. If the price of the underlying doesn’t drop below $25, you still keep the $1 premium.

The profit on a short put is limited to the premium received, but the risk can be significant. When writing a put, the writer is required to buy the underlying at the strike price. If the price of the underlying falls below the strike price, the put writer could face a significant loss. For example, if the put strike price is $25, and price of the underlying falls to $20, the put writer is facing a loss of $5 per share (less the premium received). They can close out the option trade (buy an option to offset the short) to realize the loss, or let the option expire which will cause the option to be exercised and the put writer will own the underlying at $25.

If the option is exercised and the writer needs to buy the shares, this will require an additional cash outlay. In this case, for every short put contract the trader will need to buy $2,500 worth of stock ($25 x 100 shares).

Key Takeaways

  • A short put is when a trader sells or writes a put option on a security.
  • The idea behind the short put is to profit from an increase in the stock’s price by collecting the premium associated with a sale in a short put. Consequently a decline in price will incur losses for the option writer.

Short Put Example

Assume an investor is bullish on hypothetical stock XYZ Corporation, which is currently trading at $30 per share. The investor believes the stock will steadily rise to $40 over the next several months. The trader could simply buy shares, but this requires $3,000 in capital to buy 100 shares. Writing a put option generates income immediately, but could create a loss later on (as could buying shares).

The investor writes one put option with a strike price of $32.50, expiring in three months, for $5.50. Therefore, the maximum gain is limited to $550 ($5.50 x 100 shares). The maximum loss is $2,700, or ($32.50 – $5.50) x 100 shares. The maximum loss occurs if the underlying falls to zero and the put writer needs to still buy the shares at $32.50. The loss is partially offset by the premium received.

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Short Put Butterfly Options Trading Explained: Example & Payoff Charts

Continuing further from our previous article Short Put Butterfly Options Introduction, here are the Details about Short Put Butterfly Spread Trading with Payoff Chart explained with an example
Short Butterfly Spread offers the options trader a limited risk limited profit potential – traders should get into this Short Put Butterfly Spread Option trading when they do expect the underlying stock or index to move much rather than remaining in a confined or limited price range.

What is a Short Put Butterfly Option position?
A Short Put Butterfly Option offers capped (limited) profit and capped (limited) loss potential.
The name comes from the payoff function shape (see below) which resembles a butterfly – in this case an inverted butterfly, hence the name SHORT BUTTERFLY. There are 2 LONG PUT and 2 SHORT PUTS required for this Short Put Butterfly Spread Option trading. Since it is constructed with Put options, hence the name includes PUT.
It is usually a net credit position i.e. the option trader taking the Short Put Butterfly Spread Option position can expect to receive a net option premium upfront.

Short Put Butterfly Option Payoff Function Explained with Example

How is the Short Put Butterfly Spread Option constructed or configured?
The Short Put Butterfly Spread Option can be constructed by taking 4 option positions –
1) 1 * ITM Short Put
2) 1 * OTM Short Put and
3) 2 * ATM Long Put positions.
(Want to know what is ITM, OTM, ATM in Options? See Moneyness of Options – OTM, ATM, ITM Options)
Theoretically, here is how it looks:

Can we have an example of Short Put Butterfly Spread Option ?
Suppose that IBM stock is trading at around $50 per share (the underlying) – just for an example. Using your own research or forecasting mechanism, you come to a conclusion that the IBM stock price might make a big move either direction in the next 2 months and can either reach $80 on the upside or fall down to $20 on the downside.
So this makes an ideal scenario to go for the Short Put Butterfly Spread Option Position.
Hence, you SELL (or go SHORT) the following:
1 ITM Short PUT with Strike price of $55 at a option price of $8
1 OTM Short PUT with Strike price of $45 at a option price of $3
and you BUY (or go LONG) the following
2 ATM Long PUT with Strike Price of $50 at a option price of $4 each.

Hence, you receive a net $8 + $3 = $11 for 2 Shorts, while you pay $4 + $4 = $8 for 2 buys. Overall net credit for your Short Put Butterfly Spread Option comes to $11 – $8 = $3

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