An advanced options strategy with three legs and four total options is called a long butterfly spread with puts. One put is purchased at strike price A, two puts are sold at strike price B, and one put is then purchased at strike price C. The setup results from an investor combining the beginning of a short put spread with the end of a long put spread at strike price B.
An investor who opens this position is making a wager that the stock will pin or almost pin at strike price B. The investor would keep the profits from option C if the stock did really pin at the short strikes, but options B and A would expire worthless.
Although it can be difficult to secure that pinning strike, this method has a modest entrance cost, which means decreased risk if things go south. In low-volatility situations where there is a strong likelihood of price pinning, the long butterfly spread with puts is a suitable option. Due to its limited loss, it can also be a wise decision in volatile markets, but traders should watch the trade carefully and exit it as the stock goes near the short strikes.
Profit/Loss
The difference between the higher strike price and the middle strike price is subtracted from the cost of the trade to determine the maximum profit. For instance, the maximum profit would be Rs 4.30 if the distance between points C and B were Rs 5 and the deal cost Rs 0.70.
The maximum loss would be equal to the cost of the deal, or Rs 0.70 in the same scenario.
Breakeven
There are two points where things break even. The highest strike price (point C) would be used to determine the upper breakeven threshold, and the cost of the trade would be subtracted. Therefore, the lower breakeven would be Rs 109.30 if point C had an option with a strike price of 110 and the trade cost Rs 0.70.
By adding the net debit to the lowest strike price (point A), the lower breakeven point can be determined. Therefore, our lower breakeven would be Rs 100.70 if the point A strike price was equal to Rs 100 and the trade’s cost was Rs 0.70.
Example
A trader might execute a 100/105/110 butterfly spread with options if XYZ is trading at Rs 107 and it is anticipated that it will trade flat to slightly lower over the next 45 days by purchasing one 110-strike price put, selling two 105-strike price puts, and purchasing one 100-strike price put for the following prices:
- Purchase one (Rs 5.00) XYZ 110-strike price put.
- For Rs 5.40 (Rs 2.70 apiece), sell 2 XYZ 105-strike price puts.
- For Rs 1.10, purchase 1 XYZ 100-strike price put.
- Cost in whole is Rs 0.70 debit.
The investor will have lost the full Rs 0.70 and all positions will expire worthless and be deleted from the account if the stock trades higher than Rs 110 over the next 45 days.
The trader will profit Rs 5 from the market movement, utilising the 110-strike price option, while the remaining options expire worthless if the stock trades somewhat lower to Rs 105 at expiration. Their net gain would be Rs 4.30 because they spent Rs 0.70 on the trade.
The investor would profit Rs 10 on the 110 put if the stock fell to Rs 100. The 100 put lost all of its value, and you lost Rs 5 X 2 on the short middle 105-puts for a total loss of Rs 10. The investor paid Rs 0.70 for the trade, therefore their net loss is Rs 0.70. The final result would be Rs 10 – Rs 10, meaning all profits are lost.
Conclusion
The more bearish a butterfly spread with puts becomes, while also lowering the cost of the transaction, the lower the trader sets the strike prices. However, the likelihood of success decreases when strike prices are lowered.
The implied volatility is sensitive to variations in this kind of spread. Inversely correlated with changes in implied volatility is the spread’s net price, which decreases when implied volatility increases and rises when implied volatility decreases. The trader who places this order hopes implied volatility would decrease.
A seasoned options trader should use the long butterfly spread with puts instead of a newbie.
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