Butterfly spreads are three-part strategies applied in options trading to benefit when market volatility is low with a forecast to rise in the future. Traders profit from short butterfly options when asset price moves up or down beyond the highest and the lowest strike prices. In this article, we will discuss short put butterfly and when it is a good trading strategy.
What is a short-put butterfly?
A butterfly spread is a trading strategy formed with buying and selling put or call options with the same expiry date. Short put butterfly is also a three-part strategy created by selling one put option at a higher strike rate, purchasing two put options at a lower strike price, and selling another put at an even lower strike price. All the puts have the same expiry date, and the strike prices at equidistant. The shape vaguely resembles a butterfly, hence, the name.
Let’s understand with an example.
- Short 1 ABC 105 at 250
- Long 2 ABC 100 at 150 or 300
- Short 3 ABC 95 at 125
- The net credit is 75
Here net profit is equal to net credit minus commissions paid. Traders realise a profit when stock price stays above the highest strike price or below the lowest strike price on expiration. Maximum risk/loss is the distance between the center and the lower strike price, less the net premium.
It is an advanced strategy because the profit potential is limited, but the costs are high. Since there are three strike prices, multiple commissions are paid along with the costs of opening and closing positions for the three bid-ask spreads. Because of the high costs involved, traders need to open and close positions at ‘good’ prices and ensure that risk/reward after paying commissions is favourable and acceptable by the parties involved.
Analysing short put butterfly spread
The objective of the strategy is to capture a movement in asset price or increase in implied volatility. Let’s understand the different outcomes from short-put butterfly spread.
Traders realise profit under short put butterfly when asset price expires outside the range, meaning when stock price expires lower than the lowest strike price or higher than the highest strike price.
When asset price expires above the highest strike price, all the put options expire worthlessly, and traders realise total net credit as profit. The maximum profit is the net credit minus commissions.
Maximum loss equals the difference between the center and the lowest strike price subtracting net credit minus less commission. The loss realises when asset price equals the middle strike price on expiration.
Short put butterfly has two breakevens occurring at the lowest and the highest strike prices. The first is when asset price equals the lowest strike price plus net credit.
The second breakeven occurs when the asset price is the highest strike price minus net credit.
Right market forecast
Short put butterfly realises maximum profit when the asset price is above or lower than the strike price on the expiration date. It occurs when the market volatility is low initially, but the stock price eventually moves outside the spread’s range as time passes.
Discussing short put butterfly strategy
Butterfly spreads are sensitive to volatility. Hence, profit realisation happens when the underlying asset price moves outside the lower and the higher strike prices. The forecast is, therefore, of increasing volatility. The net cost of a short-put butterfly spread falls when volatility rises and rises when volatility falls. Typically option prices rise as the earnings date approaches and fall immediately after the date is announced. So, many traders would sell a butterfly seven to ten days before the announcement of the earning date and close their position the day before the report. Profiting from the spread requires either volatility or the asset price to rise. If asset price remains unchanged on expiry and implied volatility remains low, a loss would happen.
Since it is an advanced trading strategy, patience and trading discipline are required. Patience is needed because the spread becomes profitable with the rise in implied volatility. It can be unsettling when asset prices rise and fall between upper and lower strike prices. Hence, trading discipline is necessary as small price changes in the underlying can significantly impact the profit/loss condition of the spread. Trading discipline means traders should be ready to take partial profit or loss to avoid incurring a significant loss.
Let’s understand the impact of asset price change, implied volatility, and time spent in the market on short put butterfly.
Impact of price change
Delta is a measure of change in the profitability of a position with the difference in asset price. Long puts have a negative delta, and short puts have a positive delta.
Regardless of time to expiration or stock price, the delta of short put butterfly remains close to zero. The delta value is slightly positive when the stock price rises above the upper strike price. And, the delta value is negative when the asset price closes below the lower strike price.
Change in volatility
Volatility measures the percentage change in stock price and is a crucial factor in determining option price. Usually, option price rises when volatility rises, considering asset price and time to expiry remaining unchanged. Hence, long options make money when volatility rises, whereas short options lose their worth. Accordingly, when volatility falls, the opposite scenario plays out – long options lose their values, and short options gain worth. Vega measures change in volatility.
A short put butterfly spread has positive vega, meaning the price of the short put butterfly falls with the rise of implied volatility. Conversely, when volatility decreases, the value of the short butterfly spread price rises, and it loses value. Hence, it is a strategy that applies when volatility is low but expected to rise.
Impact of time
Options tend to lose value as time passes. Its value decreases rapidly as the expiration date approaches. It is called time erosion. Theta is the measurement of how time erosion factors in the net price of the option. Long positions have negative theta, meaning their value decreases as time passes. Conversely, short positions gain value with time.
Short butterfly spreads with put options have a negative theta when the price moves within the range of the upper and lower strike prices. However, if stock prices move out of the price band, the theta value becomes positive as the expiration date approaches.
Options holders have no control over when they will need to exercise their position. Hence, the risk of early assignment always remains with entering a spread with short put positions.
Early assignment of stocks usually coincides with the declaration of dividends. It happens on the ex-dividend date, and in-the-money put options with time value less than dividend rate are more likely to be assigned.
When a short put is assigned, one with the higher strike price, the long positions and the other short put positions remain open. So when one wants to close a long trade, it is done either by selling stocks in the long position or the put at a middle strike price. However, it forfeits the spread from gaining time value.
Short put vs short call butterfly
Short put and short call butterflies are two critical options strategies. Hence, their differences make for a fascinating study.
|Short put butterfly||Short call butterfly|
|strategy||Short put butterfly is a trend neutral strategy but bullish on volatility. It assumes that asset prices will not move beyond a certain level.||Short call butterfly is a trend neutral strategy and bullish on volatility. It offers a limited risk/rewards situation.|
|Market view||It is a bullish strategy||Short call butterfly is market neutral|
|Complexity level||Beginners can apply||Reserved for advanced traders|
|Number of positions||1||4|
|When to use||When you expect the underlying price to increase marginally.||When forecasts significant rise in volatility in future.|
|Works best||When the outlook is positive, and asset price is not expected to move beyond a certain level.||When one is unsure which way the market will move but expects the underlying price to experience high volatility.|
|Advantages||It allows traders to realise a profit from time decay. And earn income in a rising or range-bound scenario.||It offers benefits in a rising volatility situation.|
|Disadvantages||It is a high-risk strategy and can result in a significant loss if the underlying price falls steeply.||Profitability depends on the extensive movement in stock price.|
A short put butterfly is a combination of a bull put spread, and a bear put spread. The bull spread consists of one put option with a higher strike price and one long center-strike put. Similarly, the bear spread combines a lower strike price put and a long center-strike put. It is a strategy when the market is steady, but volatility is expected to increase.
We hope this article has helped you understand the short-put butterfly options strategy to trade confidently in the equity options segment.
What is a short-put butterfly?
The short put butterfly options strategy is a spread consisting of four put options. It includes selling one put at a higher strike price, buying two at a central strike price, and selling one put option at a lower price. It is a bullish strategy when traders assume that the asset price will not fall beyond a certain level.
How does short put butterfly work?
It is a good strategy when the market is stable but a forecast of a moderate rise in volatility in the near future. The profitability of the butterfly strategy increases with time-lapse when asset price moves out of the spread’s price range, which is higher than the upper strike price or lower than the bottom strike price.
When should I use a short put butterfly?
One should enter a short put option strategy when market volatility is low. Usually, time to expiration and implied volatility make up the extrinsic value of an option and impact its premium. If all the other factors remain unchanged, then options with more time to expiration have a higher value.