Short Put Butterfly

The Short Put Butterfly is an involved options strategy suitable for traders expecting minimal price movement in the underlying asset but wishing to exploit heightened levels of implied volatility. The strategy is achieved by purchasing and selling put options at three distinct strike prices, but the same expiration date, to exploit theta decay while maintaining defined maximum loss.

Short Put Butterfly


The Short Put Butterfly Setup

Imagine you have a stock, XYZ Corp, that’s trading at $50. In order to construct a Short Put Butterfly, you might do something like this:

  • Buy one in-the-money put with a strike price of $55 for a premium of $6.
  • Sell two at-the-money puts with a strike price of $50 for a premium of $3 each.
  • Buy one out-of-the-money put with a strike price of $45 for a premium of $1.

This leaves a net credit of $1 ($6 received from selling the puts - $7 paid for buying the puts).


Who Should Consider It

This strategy is profitable to traders who believe the stock price will remain relatively stable around the at-the-money strike price and wish to profit from the decay of option premiums. It is especially useful when implied volatility is high, thus inflating the received premiums from the sold puts.

In the Short Put Butterfly, double the number of at-the-money puts are sold and hedged by buying puts both above and below these strikes. The thought is to try to maximize premiums received while reducing downside risk in the case the stock price would move away a significant amount from the target middle strike by holding puts that have a higher potential value.

The breakeven points for this strategy are computed by adding and subtracting the net credit received to and from the outer strikes as follows:

  • Upper breakeven: Lower strike + net credit = $45 + $1 = $46.
  • Lower breakeven: Higher strike - net credit = $55 - $1 = $54.


Sweet Spot

The optimal scenario occurs when the stock price finishes exactly at the middle strike price ($50) at expiration. Here, the sold puts expire worthless, allowing the trader to retain the full credit initially received.


Max Profit Potential

This strategy is limited in maximum profit to the net credit received at setup. In this example, maximum profit would be $1 per share, assuming the position is held to expiration and the stock price ends at the middle strike.


Loss Max

The maximum loss is limited and occurs if the stock price moves significantly below the lower strike or above the higher strike. The loss would be the difference between the strikes minus the net credit received, adjusted for the number of contracts.


Risk

While it limits possible losses, the biggest risk in the Short Put Butterfly is that the stock moves greatly and undermines the hedge positions purchased in the form of puts. This risk is potentially at its highest when the stock ends relatively near either of the outer strikes at expiration.


Time Decay

The presence of time decay (theta) favors this strategy if the stock price remains around the middle strike, because short puts decay much faster than the long puts do. The acceleration is very strong as the expiry date approaches, especially for at-the-money options.


Implied Volatility

A decline in implied volatility typically helps this strategy after the position is established since it reduces the value of at-the-money puts sold, possibly resulting in the realization of the maximum profit in a shorter time frame.


Conclusion

The Short Put Butterfly is best suited for experienced traders who expect little price movement and decreasing volatility. It is balanced with limited profit potential and controlled risk, and thus it can be an attractive strategy for income generation in stable market conditions.