Long Put Butterfly

The Long Put Butterfly is a sophisticated options trading strategy utilized when an investor anticipates minimal movement in the underlying asset's price. It's particularly effective in a low-volatility environment, allowing the trader to benefit from stability in the stock price. This strategy involves placing bets on both directions of the price movement but with limited risk, aiming for profit when the stock price is near a specific target at expiration.

The Setup

For example, let’s look at XYZ Corp, currently trading at $50. To establish a long put butterfly, you would:

Buy 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.
Buy one out-of-the-money put option with a strike price of $45 for $2.

All options have the same expiration date. The total cost (net debit) of setting up this trade is $1 ($7 + $2 - $8).

Who Should Consider It

This strategy is ideal for investors who expect the stock price to stagnate around a certain level by the expiration date and are looking to capitalize on this stagnation with a defined and minimal risk profile. It suits scenarios where significant price movements are unlikely.

Strategy Explained

In a long put butterfly, the income from the sold at-the-money puts helps offset the cost of the bought puts at the lower and higher strikes. This setup profits most if the stock price ends up at the middle strike price at expiration.

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 optimal scenario for this strategy occurs when the stock price is exactly at the middle strike price at expiration ($50 in this case). At this price, the middle strike put options reach their maximum value while the others expire worthlessly or retain minimal value, 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, occurring if the stock price is exactly at the middle strike price at expiration. Here, 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 enter the trade, which happens if the stock price is below the lower strike or above the higher strike at expiration. The maximum loss would therefore be $1 per share.

Risk

The primary risk arises if the stock price moves significantly away from the middle strike, although this is mitigated by the limited maximum loss (the net debit paid).

Time Decay

Time decay (theta) works in favor of this strategy as expiration approaches, particularly if the stock price hovers near the middle strike price. This happens because the time value erosion of the sold at-the-money options contributes positively to the overall position.

Implied Volatility

Decreasing implied volatility is beneficial to this strategy once established, as it diminishes the likelihood of substantial price changes. Lower volatility enhances the stability around the middle strike price, aligning with the strategy’s requirements.

Conclusion

The Long Put Butterfly is a prudent choice for traders forecasting minimal price movement in the underlying asset. It offers a balanced approach to risk and reward, providing a conservative strategy with defined maximum potential loss and gain, ideal during periods of low market volatility and stable asset prices.