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Option trading helps traders to take advantage of market moves and protect their portfolios. It involves contracts that permit the option buyer to buy or sell assets at a predetermined price within an agreed period.
To efficiently operate through the complexities of the market, an individual must have knowledge of various options strategies. One of those strategies is the short put butterfly. In this article, we will look at how the short put butterfly option strategy works, its advantages, and when it can be used.
What is the short put butterfly strategy?
The Short Put Butterfly is a neutral strategy that involves four put options. The Short Put Butterfly is a position established by selling one out-of-the-money put, buying two at-the-money puts, and selling one in-the-money put option.
All of the puts have the same expiration date, and their strike prices are equally spaced. It profits when the asset price does not decline below a certain level. It is created for a net credit and both its potential profit and maximum risk are capped.
Maximum profit can be achieved if the stock price is above the higher or below the lower strike at expiration. The maximum risk occurs if the stock price equals the centre strike price at expiration.
How does the short put butterfly strategy work
The Short Put Butterfly Strategy is a three-part strategy involving the use of put options. Here’s how it works:
- Sell a put at a higher strike price: This is the first part of the strategy. You sell a put option with a strike price above the current market price of the underlying asset.
- Buy two puts at a lower strike price: The second part involves purchasing two put options at prices that are below those for which they are currently trading in the market.
- Sell one put at an even lower strike price: Finally, you sell an additional put option with a strike price that is still further below any of those that came before it.
The put options involved in this strategy are for having the same expiration date, while the strike prices are equidistant. The strategy is established for a net credit, and both the potential profit and maximum risk are limited.
The maximum profit is equal to the net premium received minus commissions, and it is realized if the stock price is above the higher strike price or below the lower strike price at expiration. The maximum risk equals the distance between the centre and lower strike prices less the net premium received.
This strategy is considered advanced due to its limited profit potential in dollar terms and its relatively high costs. Since the strategy involves three different strike prices, there are multiple commissions to consider, along with three bid-ask spreads incurred when opening and closing the position.
It’s important to note that this strategy is neutral on market direction but plays on the possibility of a rise in volatility. The risks and rewards are predetermined and capped in the short-put butterfly position. This strategy, which involves receiving a net credit, is characterized by its directional neutrality. Consequently, it features two breakeven points:
- Lower breakeven point = lower strike (+ Plus) net premium received
- Upper breakeven point = upper strike (– Minus) net premium received
The maximum profit potentials are achieved when the price of the underlying security crosses either of the breakeven points, which can only happen when volatility rises and price changes rapidly. However, since a limited risk-reward profile characterizes the strategy, the potential gains are confined to the amount of option premium received.
On the other side, when volatility shrinks, and prices remain unchanged or within the two breakeven points. The maximum potential loss, though limited, necessitates some calculation:
Loss = (Lower strike – middle strike + net premium received)
When using this strategy, it’s crucial to keep in mind that the strike prices are set equally apart from each other. This means that the difference between the lower and middle strike is the same as the difference between the middle and higher strike prices.
Now, let’s illustrate a short put butterfly spread example.
Short put butterfly example
Here’s an example:
- Buy 2 put options at a middle strike price. For instance, buy 2 put options of Nifty50 at a strike price of 17,550 at ₹165.
- Sell 1 out-of-the-money put option at a lower strike price. For instance, sell one put option at strike 17,450 for ₹120.
- Sell 1 in-the-money put option at a higher strike price. For instance, sell one put option at a strike price of 17,650 for ₹225.
This results in a net inflow of ₹15. The maximum profit potential is the net credit received lesser commissions. The maximum risk of the short put butterfly strategy is calculated as the difference between the middle and lowest strike prices, reduced by the net credit earned and excluding commissions.
There are two breakeven points: the lower one occurs when the stock price equals the short put’s lower strike plus the net credit received, while the upper breakeven point is when the stock price equals the higher strike short put minus the net credit.
When to initiate the short put butterfly strategy?
The aim of a short-put butterfly is to profit from quick shifts in the prices of underlying assets. When prices change rapidly, volatility increases. Higher volatility means higher option prices, while lower volatility results in lower option prices.
This strategy is best initiated when volatility in asset prices is low, but it demands patience and discipline. You need to wait for stock prices to rise or for volatility to increase. However, you should also understand the short put butterfly vs short call butterfly difference to know this strategy better.
As the expiration date approaches, even a slight movement in the underlying stock’s price can significantly affect option prices. Therefore, it’s important to be disciplined, book small losses, and take partial profits before aiming for bigger gains.
Conclusion
Learning about options strategies like the short put butterfly can boost your investing expertise and move you closer to your financial dreams.
Take time to grasp the basics and risks involved so you can make wise choices and navigate the market confidently. Don’t forget to consider your risk tolerance and financial goals before diving in. And for more learning, check out StockGro
FAQs
A short put butterfly profits when the underlying asset’s price remains within a defined range upon expiration. This strategy benefits from time decay and minimizes losses if the price moves beyond the selected range.
A short put butterfly is ideal when you anticipate minimal price movement in the underlying asset. It’s beneficial in neutral or mildly bullish market conditions, providing a limited-risk, limited-reward approach.
The main risk of a short put butterfly is limited profit potential if the underlying asset’s price moves significantly outside the expected range. Additionally, losses can occur if the price moves beyond the breakeven points.
To set up a short put butterfly, sell one put option at a specific strike price, then purchase two put options at lower and higher strike prices. Ensure the strike prices create a defined range where you expect the underlying asset’s price to remain.
Yes, you can adjust your short put butterfly position by rolling the options to different strike prices or expiration dates if the market outlook changes. Adjustments can help manage risk and optimize potential profits.
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