A butterfly spread is an advanced options trading strategy that allows traders to profit from minimal price movements in the underlying asset while limiting their risk exposure. It’s a non-directional strategy, meaning it works best when the trader expects the asset to stay within a specific price range before the options expire. Although the butterfly spread can be constructed with either calls or puts, we will focus on the butterfly spread using puts in this explanation.
1. Overview of the butterfly spread using puts
A butterfly spread using puts consists of three different strike prices and involves the purchase and sale of four put options with the same expiration date. The strategy aims to capitalize on low volatility in the underlying asset, allowing the trader to benefit if the price stays within a certain range.
The butterfly spread using puts combines elements of both a bull put spread and a bear put spread. This combination helps to define the potential risk and reward for the strategy. It has a limited risk and a limited reward, making it ideal for traders who have a neutral outlook on the asset.
2. How the butterfly spread using puts works
A butterfly spread using puts consists of the following steps:
Buy one in-the-money (ITM) put at a higher strike price.
Sell two at-the-money (ATM) puts at a middle strike price.
Buy one out-of-the-money (OTM) put at a lower strike price.
All options in the spread have the same expiration date. The combination of these options creates a "butterfly-shaped" profit and loss graph, hence the name.
Example:
Let’s assume a trader is using this strategy on Stock XYZ, which is currently trading at $50. The trader believes the stock will not move significantly by the options expiration date. The trader sets up a butterfly spread with the following put options:
Buy 1 ITM put at a strike price of Rs.55 for a premium of Rs.7.
Sell 2 ATM puts at a strike price of Rs.50 for a premium of Rs.4 each.
Buy 1 OTM put at a strike price of Rs.45 for a premium of Rs.2.
3. Net Cost and Maximum Risk
The net cost of the trade is calculated by subtracting the premiums collected from the premiums paid:
Premiums paid: Rs.7 (for the Rs.55 put) + Rs.2 (for the Rs.45 put) = Rs.9
Premiums received: Rs.4 (for the first Rs.50 put) + Rs.4 (for the second Rs.50 put) = Rs.8
Net cost = 9 (total premiums paid) – Rs.8 (total premiums received) = Rs.1
The net cost of Rs.1 (or Rs.100 since each options contract covers 100 shares) is the maximum risk in the trade. This is the maximum loss the trader can experience, as it represents the initial investment in the strategy.
4. Maximum profit potential
The maximum profit occurs if the price of the underlying asset is equal to the middle strike price (i.e., the ATM strike) at expiration. In this case, the two short put options (the ones the trader sold) expire worthless, and the long ITM and OTM puts have a value based on their respective strike prices.
Using the example above, if Stock XYZ is exactly $50 at expiration, the trader’s profit can be calculated as follows:
The Rs.55 put will be worth Rs.5 (because Rs.55 – Rs.50 = Rs.5).
The Rs.50 puts expire worthless.
The Rs.45 put will also expire worthless.
In this case, the total value of the long Rs.55 put is Rs.5, and since the trader initially paid Rs.1 to set up the trade, the maximum profit is:
Maximum profit = Rs.5 (value of Rs.55 put) – Rs.1 (initial cost) = Rs.4
Therefore, the trader stands to make Rs.4 (or Rs.400 since each contract represents 100 shares) if the underlying stock price finishes exactly at the middle strike price of Rs.50 at expiration.
5. Breakeven points
The breakeven points for a butterfly spread using puts can be calculated as follows:
Upper breakeven point = middle strike price + net premium paid.
Lower breakeven point = middle strike price - net premium paid.
In our example:
Upper breakeven = Rs.50 + Rs.1 = Rs.51
Lower breakeven = Rs.50 – Rs.1 = Rs.49
Thus, the stock price must be between Rs.49 and Rs.51 at expiration for the trader to at least break even.
6. Profit and loss scenarios
The butterfly spread using puts has a specific profit and loss profile that depends on where the underlying asset's price finishes at expiration relative to the strike prices. Here’s a breakdown:
Scenario 1: Price Finishes at Middle Strike Price
If the price of Stock XYZ is exactly Rs.50 at expiration, the trader experiences the maximum profit. The Rs.55 put will have intrinsic value, while the Rs.50 and Rs.45 puts will expire worthless. The maximum profit is the difference between the middle and higher strike prices minus the net cost of the trade.
Scenario 2: Price Finishes Between Breakeven Points
If Stock XYZ is between Rs.49 and Rs.51 at expiration, the trader will experience a partial profit. The value of the Rs.55 put will offset the loss in the other positions. The closer the stock price is to the middle strike, the larger the profit.
Scenario 3: Price Finishes Below Lower Breakeven
If the price of Stock XYZ drops below the lower breakeven point (i.e., below Rs.49 in our example), the trader will incur the maximum loss. Both the ITM and OTM puts will have intrinsic value, but the net loss will equal the initial premium paid for the trade, which is the maximum risk.
Scenario 4: Price Finishes Above Upper Breakeven
If Stock XYZ finishes above Rs.51, all put options will expire worthless, and the trader will lose the initial premium paid (Rs.1 in our example), which is the maximum loss.
7. When to use a butterfly spread with puts
This strategy is ideal when:
The trader has a neutral outlook on the underlying asset.
The trader expects low volatility, meaning the stock is unlikely to move significantly before the options expire.
The trader wants to limit risk while also limiting potential rewards. The butterfly spread is a cost-effective way to take advantage of a narrow trading range.
8. Advantages of the butterfly spread with puts
Limited risk: The maximum loss is known upfront and limited to the initial premium paid.
Cost-effective: This strategy typically requires a low initial investment, as it involves selling two options and buying two others.
Defined profit range: It provides an opportunity for profit if the underlying asset remains close to the middle strike price at expiration.
9. Disadvantages of the butterfly spread with puts
Limited reward: The maximum profit is capped and occurs only if the stock price finishes exactly at the middle strike price.
Low volatility requirement: This strategy will not perform well in highly volatile markets where the underlying asset moves significantly in either direction.
Complexity: The butterfly spread involves multiple options at different strike prices, which can make it more complex to execute and manage compared to simpler strategies like a single long or short position.
10. Conclusion
The butterfly spread using puts is a useful strategy for traders who expect little movement in the underlying asset and want to profit from this scenario while minimizing their risk. It requires a neutral view on the market and works best in low-volatility environments. The defined risk and reward make it an appealing option for experienced traders, but its complexity and reliance on precise price movement can make it challenging for beginners. Understanding the mechanics, breakeven points, and profit potential is crucial for successfully implementing this strategy.
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