Long Put Butterfly Options Strategy
What is a Long Put Butterfly Strategy?
A long put butterfly strategy is an options trade for investors who expect that the stock price will not change extensively within a certain period. For instance, an investor analyses the market for some time and notices that the stock prices remain range-bound. He might assume that this will continue, and he predicts a strike price which the stocks would be at during expiry and implements the long put butterfly strategy.
A long put butterfly strategy comprises a three-step process that entails simultaneous selling and purchasing of puts. It is a combination of the short put and long put spread when the volatility in the market is low. The lower and higher strike options must be equidistant from the middle strike point. It is also important to remember that all the options must have the same expiration date in the long put butterfly strategy.
An investor gets the maximum yield by implementing a long put butterfly spread if the stock price at the time of expiration coincides with the middle strike price. So, when you establish your positions, if the stock price is about the middle strike price, the forecast must be for the market to remain unchanged or neutral. However, if the stock price is above the mid-strike price, the forecast must be for a fall in the stock price at expiry. If the current stock price is below the ATM, then a bullish market will be the best bet for an investor.
A long put butterfly spread is popular among investors who wish to undertake a high-yielding trade at nominal costs. Although this is a low-risk strategy, it is equally essential to bear in mind that the profits from this spread can be merely decent at the most.
Basic Overview
Let us assume that Bank Nifty has been remarkably consistent and non-volatile, and its stocks have been trading within a narrow range for quite some time. How do you use this market trend to your advantage?
A seasoned options trade investor might guess the price of stocks at expiration and sell puts at that price using the expertise and knowledge. So, moving stock prices within a bound range is the key to devising an efficient long put butterfly strategy.
Technical Perspective
It is not possible to predict the price at which stocks will trade in the future if the market is volatile. However, if an investor analyses the stocks over a period (52 weeks) and sees that the stocks have been trading within a tight range, he might detect the price at expiry by studying the market trend.
In a situation where the spot price of the stocks is below the middle strike price, implementing a long put butterfly strategy will only result in a good yield if the market is bullish. Therefore, it is imperative to study and analyse the market trends before implementing any options trade strategy.
Quantitative Approach
A long put butterfly spread is ideal when an investor can correctly gauge the price at which the stocks will trade on expiry. A low volatile market aids in guessing the price accurately. It is a good strategy for investors with risk aversion, as this strategy caps the loss you can incur.
Policy Note
Investors implement a long put butterfly spread when they expect a very minimal rise or fall in trading prices in the market. The long put butterfly strategy works in a ratio of 1-2-1, much like its counterpart long call butterfly spread. A long put butterfly strategy is a neutral strategy that involves buying one lower strike put at ITM (in the money), selling two middle strike puts at ATM (at the money), and buying one higher strike put at OTM (out of the money).
The extreme strike points (wings) must lie at an equal distance from the middle strike point (body). It is important to note that all the options must have the same expiration cycle. Since this strategy benefits from low volatile markets and operates within a range, it is crucial to establish the positions when the expiration is not too far away. This does not allow the underlying to change beyond the upper or lower break-even points significantly.
Maximum Profit: The maximum profit which can be realised through this strategy is when the stock price at expiry equals the middle strike price of the short puts. The maximum profit can be calculated as: the difference between two adjacent strikes minus the net debit (premium paid).
Maximum Loss: An investor incurs maximum loss if the market closes with stock prices beyond the lowest or highest strike prices. The maximum loss is capped at the net premium paid.
Upper Break-even Point: The stock price equals the highest strike price minus the net premium.
Lower Break-even Point: The stock price equals the lowest strike price plus the net premium.
When To Apply A Long Put Butterfly Strategy?
Let us demonstrate the long put butterfly strategy through Bank Nifty. Bank Nifty price is INR 37000. The lot size is 25. After much analysis and deliberation, an investor observes that Bank Nifty has been trading within a narrow range for a long time. Therefore, the investor expects the prices will not fluctuate much on expiry.
The investor applies the long put butterfly strategy to his options trading. Therefore, he buys one long put of INR 36900 at a premium of Rs 80, sells two short puts of INR 37000 at a premium of INR 170 each, and simultaneously buys a long put of INR 37100 at a premium of INR 300.
| Strike Price | Premium | Total Premium (Premium*Lot size) | |
|---|---|---|---|
| Buy 1 Long Put | 36900 | 80 | 2000 |
| Sell 2 Short Puts | 37000 | 170*2 | 8500 |
| Buy 1 Long Put | 37100 | 300 | 7500 |
Net Debit= 40 (80+300-170*2)
Total Premium Paid= 1000 (2000+7500-8500)
Upper break-even= 37060 (37100-40)
Lower break-even= 36940 (36900+40)
Maximum Possible Loss= 1000
Maximum Possible Profit= ((37000-36900)-40))*25= 1500
Note- All the figures are in Rs.
Let us look at a long put butterfly strategy table for better clarification.
| Closing Price of Bank Nifty | Profit/Loss from 1 Long Put bought at 37100 | Profit/Loss from 2 Puts sold at 37000 | Profit/Loss from 1 Put bought at 36900 | Total Profit/Loss |
|---|---|---|---|---|
| 37200 | -300 | 340 | -100 | -60 |
| 37100 | -300 | 340 | -100 | -60 |
| 37000 | -200 | 340 | -100 | 40 |
| 36900 | -100 | 140 | -100 | -60 |
| 36800 | 0 | -60 | 0 | -60 |
Perks of Long Put Butterfly Strategy?
Let us discuss some benefits of the strategy to determine whether it is worth it.
- This is not a costly trading strategy. Hence, it allows options traders to undertake high yielding at lower costs.
- The maximum loss possible is limited, irrespective of the market performance of the stocks.
- The risk to reward ratio of a long put butterfly spread is decent as there is enough margin for the stocks to perform
Disadvantages of Long Put Butterfly Strategy?
- Markets do not always play by the rules. Hence, a low volatile market can suddenly start showing flux that can hurt the strategy's profitability.
- A long put butterfly spread requires a substantial margin as the process involves the sale of two options at the same strike price.
- There is a risk of losing the entire premium paid if the stock prices at the expiration move beyond the lower or higher strike prices.
Summary
Therefore, a long put butterfly spread is a lower risk and capped profit strategy implemented when investors think that the underlying assets will not move much during expiration. It is a non-directional strategy that offers a limited risk trading option to investors, although it also comes with limited profit. This strategy will work the best if the market is potentially non-volatile and you can safely predict stock prices at expiry.