Short Put Butterfly

A short put butterfly is structured with a short call at upper strike, long a call and long a put at middle strike, and short a put at lower strike.  The upper and lower strikes(wings) must both be equidistant from the middle strike(body), and all the options must be the same expiration.  An alternative way to think about this strategy is long a straddle and short a strangle.  It could also be considered as a bull call spread and a bear put spread.

Market Outlook

Market participants looking for sharp move either up or down in underlying stock during the life of the options.

When to Use

An investor often employs a long butterfly strategy when they are looking for a large, sharp move in the underlying over the life of the options.

Profit & Loss Chart

Benefit

Investors generally initiate short put butterfly positions when they are expecting a large move in the underlying in either direction. The potential profit and loss are both very limited.  In essence, a long butterfly at expiration has a minimum value of zero and a maximum value equal to the distance between either wing and the body.  An investor who buys a long butterfly pays a premium somewhere between the minimum and maximum value, and profits if the butterfly’s value moves toward the maximum as expiration approaches.

Risk & Reward

Maximum Profit: Limited
Maximum Loss: Limited

The maximum gain would occur should the underlying stock be outside the wings at expiration.  In that case either both calls or both puts would be in-the-money.  The profit would be the difference between the body and either wing, less the premium paid to initiate the position.

The maximum loss would occur should the underlying stock be at the body of the butterfly at expiration.  In that case all the options would expire worthless, and the premium paid to initiate the position would have been lost.

Break Even Point

The strategy breaks even if at expiration the underlying stock is either above or below the body of the butterfly by the amount of premium paid to initiate the position.

Volatility Changes

Increase In Volatility: Positive Effect
Decrease In Volatility: Negative Effect

The effect of an increase in implied volatility, all other things equal, would benefit a long butterfly position due to the fact that their is a greater chance of the underlying making a large enough move over the life of the options. On the other hand, a decrease in implied volatility would have a negative effect on the value of the position.

Time Decay (Theta)

Negative Effect

The effect of time decay on this strategy has a negative effect (or negative theta). The underlying must make a large enough move over the life of the options to realize a profit. If the underlying doesn’t move as expiration approaches, the position value will suffer.