Short Put Butterfly

The Short Put Butterfly is a complex options strategy designed for traders who expect minimal movement in the underlying asset's price but want to take advantage of elevated levels of implied volatility. This strategy involves a combination of buying and selling put options at three different strike prices but with the same expiration date, aiming to benefit from the theta decay while managing risk through defined maximum loss.

The Setup

Consider a stock, XYZ Corp, which is currently trading at $50. To set up a Short Put Butterfly, you might proceed as follows:

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

Who Should Consider It

This strategy is suitable for traders who believe the stock price will remain relatively stable around the at-the-money strike price and who are looking to profit from the decay of option premiums. It's particularly useful when implied volatility is high, as this inflates the premiums received from the sold puts.

Strategy Explained

In the Short Put Butterfly, the trader sells double the number of at-the-money puts and hedges these positions by buying puts both above and below these strikes. The intent is to maximize the receipt of premiums while controlling downside risk by owning puts that will increase in value if the stock price moves significantly away from the target middle strike.

Breakeven Process

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

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

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

Max Loss

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 the Short Put Butterfly limits potential losses, the primary risk is that the stock moves significantly, reducing the effectiveness of the hedge positions (bought puts). The risk is most substantial when the stock price ends near the outer strikes at expiration.

Time Decay

Time decay (theta) works in favor of this strategy if the stock price remains near the middle strike, as the value of the short puts decays faster than that of the long puts. This decay accelerates as expiration approaches, particularly for the at-the-money options.

Implied Volatility

A decrease in implied volatility typically benefits this strategy after the position is established because it reduces the value of the at-the-money puts sold, potentially leading to a quicker realization of the maximum profit.

Conclusion

The Short Put Butterfly is best employed by experienced traders who anticipate minimal price movement and declining volatility. It offers a balanced approach with limited profit potential and controlled risk, making it an attractive strategy for generating income in stable market conditions.