Long Put Butterfly

The Long Put Butterfly is a sophisticated options trading strategy employed when an investor anticipates little price action in the underlying stock. It's most appropriate in a low-volatility environment, where the trader can make money from stability in the stock price. The strategy is wagering on both sides of the price move but with little risk, anticipating making money when the stock price is near a target at expiration.

Long Put Butterfly


The Long Put Butterfly Setup

For example, XYZ Corp is quoted at $50. To take a long put butterfly, you would:

  • Purchase one in-the-money put option with a strike price of $55 for $7.
  • Sell two at-the-money put options with a strike price of $50 for $4 each.
  • Purchase one out-of-the-money put option with a strike price of $45 for $2.

The options all have the same expiration date. The cost (net debit) of opening this position is $1 ($7 + $2 - $8).


Who Should Consider It

This strategy is ideal for investors anticipating the stock price to level off at some point by expiration and wanting to make money from this stagnation with a low-risk and defined profile. It is optimal for those situations where large price movements are not expected.


Strategy Explained

In a long put butterfly, the proceeds from the sold at-the-money puts are utilized to pay for the purchased puts at the lower and higher strikes. This setup makes the most money when the stock price at expiration is at the middle strike price.


Breakeven Process

There are two breakeven points for the long put butterfly:

  • Lower breakeven: Lower strike price + net debit.
  • Upper breakeven: Higher strike price - net debit.

For the XYZ example, these would be:

  • $45 + $1 = $46
  • $55 - $1 = $54


Sweet Spot

The ideal scenario for this strategy is when the stock price is precisely at the middle strike price at expiration ($50 in this example). At this price, the middle strike put options are most valuable and the others expire worthless or worth little, maximizing the trader’s profit.


Max Profit Potential

The maximum profit for the long put butterfly is the difference between the middle and lower (or upper) strike prices minus the net premium paid, if the stock price is precisely at the middle strike price at expiration. In this example, it would be:
$5 (difference between $50 and $45) - $1 (net debit) = $4 per share.


Max Loss

The maximum loss is limited to the initial net debit paid to initiate the trade, which happens if the stock price is below the lower strike or above the higher strike at expiration. The maximum loss would thus be $1 per share.


Risk

The biggest risk is if the stock price moves away from the middle strike, though this is diminished by the limited maximum loss (the net debit paid).


Time Decay

Time decay (theta) is helpful to this strategy as expiration approaches, particularly if the stock price is near the middle strike price. This is because the loss of time value in the sold at-the-money options contributes to the positive impact of the overall position.


Implied Volatility

Decreasing implied volatility is helpful to this strategy once in place, as it decreases the likelihood of big price movements. Lower volatility increases the stability around the middle strike price, which is what the strategy needs.


Conclusion

The Long Put Butterfly is a conservative investment vehicle for investors that anticipate minimal price movement in the underlying asset. It offers a risk-reward balanced strategy with precise maximum possible gain and loss, which is optimal during times of low market volatility and flat asset prices.