Short Put Butterfly : Profit From Increased Volatility

Introduction To Short Put Butterfly

 

Short Put Butterfly

The short put butterfly is an options strategy that uses put options, as its name suggest, to capitalise on anticipated high volatility on the underlying security. The short put butterfly is created by selling to open 1 in the money put option contract, buying to open 2 at the money put option contracts and selling to open 1 out of the money put option contracts. These put options have the same expiration date, are derived from the same underlying security but have three different exercise(strike) prices.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited potential loss
Step 7 : Maximum loss calculation for a short put butterfly
Step 8 : Limited potential profit
Step 9 : Calculate Profit
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade – Executing a short put butterfly
Step 12 : Exit Trade & Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

It is important for the trader to conduct some economic, fundamental and technical analysis. Scan the near term for events that may cause volatility. That event may be an expected rise in inflation or a quarterly earnings results.

The trader should look out for chart patterns that imply a breakout. Stagnant prices are not good for such a strategy. There has to be some movement in the prices.

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 : Outlook

The short put butterfly is considered a neutral options trading strategy. It aims to capitalise on increased volatility of the underlying security.

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Step 3 :Study the option chain

Examine the options chain. Select the options to be used in the short put butterfly. Know the premiums of the options as it can be used to calculate the breakeven points in the next step.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

The payoff diagram of a short put butterfly has 2 breakeven points. The 2 breakeven price points at which there is neither profit nor loss are termed as the “lower breakeven point” and the “upper breakeven point”.

The lower breakeven point can be calculated as:

Lowest strike price + net credit received

The upper breakeven point is:

Highest strike price – net credit received

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Step 5: Understand Your Profit Zones

 

Short Put Butterfly

After the breakeven points have been calculated, the options trader will understand the where the profit zone is. The profit zone is any price point outside of the breakeven points as shown in the  diagram here.

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Step 6 : Limited potential loss

Theoretically, the trader stands to make the maximum loss when the price of the underlying security is equal to the strike price of the long puts, that is, the middle strike prices of the short put butterfly trade. When that happens, the middle strike puts and the lower strike puts expire worthless. The higher strike puts however end up in the money. When the trade is exited at that point, the trader will make a maximum loss.

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Step 7 : Maximum loss calculation for a short put butterfly

The maximum loss occurs at only 1 price point, the strike price of the middle strike puts. That being the case, the maximum loss calculation can be calculated as :

Strike price of highest strike put – strike price of middle strike put – initial net credit received + commissions paid to the broker

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Step 8 : Limited potential profit

The short put butterfly is an options strategy with a limited profit potential due to the way it is structured. The maximum profit occurs when the price of the underlying security is:

  • greater or equal to the highest strike price
  • less than or equal to the lowest strike price

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Step 9 : Calculate Profit

Maximum profit calculation for a short put butterfly

When the price of the underlying security is greater than or equal to the highest strike price or less than or equal to the lowest strike price, a maximum profit is realisable.

The maximum profit can be calculated as:

Initial credit received – commissions paid to the broker

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Step 10 : Calculate Risk & Reward Ratio

After the maximum profit and risk(loss) has been calculated, the options trader should calculate the risk and reward ratio. He should ask : Is the trade attractive on risk and reward basis for one to execute the trade?

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade – Executing a short put butterfly

A trader who executes a short put butterfly anticipates a spike in volatility. To execute a short put butterfly trade, he :

  • Short 1 in the money put. This is the put with the highest strike price.
  • Long 2 at the money puts. These are the puts with the middle strike price.
  • Short 1 out of the money put. This is the put with the lowest strike price

The ratio is thus 1 : 2 : 1 .

Therefore, a trader can short 2 ITM puts, long 4 ATM puts and short 2 OTM puts and it will still be considered a short put butterfly.

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Step 12 : Exit Trade & Record Trade In Diary

Last but not least, exit the trade and record the trade’s performance in a diary or a journal. The options trader should do some personal reflection and find ways to improve on his personal trading algorithm.

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Example Of A Short Put Butterfly

The price of AAA Corp is trading at $60. A trader decides to executes a short put butterfly by:

  • Short 1 December 70 put @ $11
  • Long 2 December 60 puts @ $4 each
  • Short 1 December 50 put @ $1

The net credit received is thus:

($11 + $1 – $4 x 2) x 100 = $400

When the price of AAA Corp remains at $60 on expiration:

Beginning value End Value Overall Profit(+) or Loss(-)
Short 1 Dec 70 put $11 $10 $1
Long 2 Dec 60 puts $4 $0 -$4 x 2 = -$8
Short 1 Dec 50 put $1 $0 + $1
Overall loss -$6

The total loss is thus:

$6 x 100 = $600

The total loss in this case is the maximum loss because the price of the underlying security is equal to the middle strike price.

The maximum loss can also be calculated as:

($10 – $4) x 100 = 600

This is the difference between the highest strike price and middle strike price less the net credit received per share, multiplied by a 100 as every options contract represent 100 shares of the underlying security.

If the price of AAA Corp trades at $80:

Beginning value End Value Overall Profit(+) or Loss(-)
Short 1 Dec 70 put $11 $0 $11
Long 2 Dec 60 puts $4 $0 -$4 x 2 = -$8
Short 1 Dec 50 put $1 $0 + $1
Overall profit +$4

The total profit can be calculated as:

$4 x 100 = $400

As you can see, this is also the maximum profit which is equal to the net credit received. In conclusion, the greater the volatility and movement of the price of the underlying security in either direction, the greater the chance of the short put butterfly experiencing a maximum profit.

 

Long put butterfly vs short put butterfly

The short put butterfly is executed in anticipation of high volatility but the long put butterfly is executed in anticipation of low volatility. Both strategies are created using put options.

 

Short put butterfly vs short call butterfly

While the short put butterfly is created with put options, the short call butterfly is created with call options.

Similarities between Short put butterfly, short butterfly, short condor and reverse iron condor

The short put butterfly, short butterfly, short condor and reverse iron condor are strategies that have similar risk and reward profile. Each strategy has the potential for a limited profit and loss and capitalise on high volatility of the underlying security. In a stagnating environment, these strategies could result in losses.

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