Execute A Long Put Butterfly : Profit From Low Volatility Conditions

Introduction To Long Put Butterfly

The long put butterfly is a low volatility options trading strategy. It aims to capitalise on insignificant or stagnating prices of the underlying security. The long put butterfly, is created with a middle strike prices, a lower strike price and a higher strike price. Due to the way it is constructed, it is a limited profit and limited risk options strategy.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 :Outlook – Low Volatility
Step 3 :Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited loss
Step 7 : Calculate Loss
Step 8 : Limited potential profit
Step 9 : Maximum profit calculation
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing A Long Put Butterfly
Step 12 : Exit Trade
Step 13 : Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

Range bound or stagnating conditions is what a trader is looking out for. The markets should trade sideways preferably or stagnate. This applies to the underlying security as well. Conduct some research on the economy and the fundamentals of the underlying to ascertain that those conditions will persist. Some suggested chart patterns to look out for are:


As a trader, I want to know that the price of the underlying security will fluctuate between the breakeven points. In this way, maximum profit may be attainable.

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

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Step 2 :Outlook – Low Volatility

The ideal scenario is that the price of the underlying security stagnates and stays unchanged till expiration. When that happens the trader can realise a maximum profit.

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Step 3 :Study the option chain

The  trader should study the options chain and determine the options to be used to construct the long put butterfly.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

Because the long put butterfly belongs to a family of spreads called wingspreads, the long put butterfly has two breakeven points. It has an upside breakeven point and a downside breakeven point. At these 2 price points, there is neither profit nor loss.

The upside breakeven point = Exercise price of put with highest exercise price – net debit

The downside breakeven point = Exercise price of put with lowest exercise price – net debit

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Step 5: Understand Your Profit Zones

After performing breakeven analysis, the trader can understand where the profit zones lie.

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Step 6 : Limited loss

The maximum loss is limited to the net debit paid to initiate the long put butterfly plus any commissions paid to the broker.The price occurs when the price of the underlying security is :

    • greater than or equal to the strike(exercise) price of the bought put with the highest strike(exercise) price
    • less than or equal to the strike(exercise) price of the lower strike(exercise) bought put with the lowest strike(exercise) price

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Step 7 : Calculate Loss

The maximum loss can be calculated as equal to the net debit paid plus commissions paid to the broker.

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Step 8 : Limited potential profit

The maximum profit occurs when the price of the underlying security is equal to the exercise price of the written put on expiration. Hence, there is only 1 price at which the trader receives the maximum profit – the exercise(strike) price of the short put.

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Step 9 : Maximum profit calculation

The profit can be calculated as :

Exercise price of the bought put – Exercise price of the short put – net debit – commissions paid to the broker

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Step 10 : Calculate Risk & Reward Ratio

After calculating the maximum loss and the potential profit based on a price target in the underlying security, the option trader can calculate the risk and reward ratio. The risk and reward ratio must be attractive relative to other trades that can capitalise on low volatility conditions. Also, the risk and reward ratio of this trade can be compared to other long put butterflies which was executed in the past.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade : Executing A Long Put Butterfly

All put options involved in a long put butterfly have the same expiration date. A trader that executes a long put butterfly will:

  • Long 1 out of the money put
  • Write 2 at the money puts
  • Long 1 in the money put

The above is 1 set of a long put butterfly. An options trader can execute multiple sets. For example, an options trader can:

  • Long 5 out of the money put
  • Write 10 at the money puts
  • Long 5 in the money put

Hence, if the trader executes 5 sets of a long put butterfly.

The ratio is hence always 1 : 2 : 1 for OTM puts, ATM puts and ITM puts respectively.

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Step 12 : Exit Trade

Consider exiting the long put butterfly when the price point is near the point where the maximum profit has been reached. Calculate and make sure that the trade is profitable if liquidated at that point. Also, consider exiting when the price of the underlying security trades outside the breakeven points especially if there is little possibility that the price will revert to a range between the breakeven points.

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Step 13 : Record Trade In Diary

Record the long put butterfly trade in a diary. Identify weaknesses and fine tune the trading process. Look for alternative strategies that could be used instead.

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Example

ABC Corp is trading at a price of $40. A trader executes a long put butterfly by:

  • Long 1 July 35 put @ $1
  • Write 2 July 40 puts @ $2 each
  • Long 1 July 45 put @ $7

The net debit is thus :

($7 – $2 x 2 + $1) x 100 = $400

if the price of ABC Corp trades at $40 on expiration, the July 35 and July 40 puts will expire worthless. The July 45 put will have an intrinsic value of $5.The profit is thus:

$2 x 2 – $1 – ($7 – $5) = $1

$1 x 100 = $100

This also happens to be the maximum profit. The maximum profit can also be calculated as :

strike(exercise) price of bought put with highest strike(exercise) price  – strike(exercise) price of short put – net debit.

($45 – $40) x 100 – $400 = $100

The maximum loss occurs when it is trading below $35 or above $45. Whatever gains in option premium is more than offset by the losses in option premium. The good news however is that the maximum loss is equal to the net debit plus any commissions paid to the broker.

Long put butterfly vs long call butterfly

The long put butterfly is created with put options while the long call butterfly is created with call options instead.

Read : Execute An Iron butterfly to profit from low volatility  as the iron butterfly has a comparable payoff profile.

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