A put butterfly, also known as a long butterfly, is a multi-leg, risk-defined, neutral strategy with limited profit potential. Put butterflies have four put option components with the same expiration date: two short puts sold at the same strike price, one long put purchased above the short strikes, and one long put purchased below the short strikes. A put butterfly is a combination of a bear put debit spread and a bull put credit spread sold at the same strike price. The long put options are equidistant from the short put options.
Entering a put butterfly will typically result in paying a small debit. The initial amount paid to enter the trade is the maximum defined risk. The profit potential is limited to the difference between the long and short strikes minus the debit paid.
The strategy looks to take advantage of a drop in volatility, time decay, and little or no movement from the underlying asset.
Put butterflies are market neutral and have no directional bias. Put butterflies depend on minimal movement from the underlying stock to be profitable. For the position to reach maximum profit potential, the underlying stock price would need to close at the inside short strike prices at expiration. The initial cost to enter the position is the most an investor can lose. If the stock price closes above the higher strike long put or below the lower strike long put, the maximum loss will be realized. A put butterfly is used when the underlying asset is expected to stay within a small range before expiration.
Put butterflies are essentially a short straddle with long put option protection purchased above and below the short strikes to limit risk. The goal is for the stock price to close at the centered short strikes at expiration. This results in one long put option (below the short strikes) expiring out-of-the-money and one long put option (above the short strikes) expiring in-the-money.
The maximum profit is achieved by selling the in-the-money long put option and buying back the short put options at little or no cost. The difference remaining between selling the in-the-money long put option and purchasing the short options, minus the original debit paid, is the realized profit. The maximum loss would occur if the stock price closed above the higher strike long put or below the lower strike long put at expiration.
If the stock price closes above the higher long put, all options would be out-of-the-money and expire worthless, and the original debit paid would be lost. If the stock price closes below the lower long put, all options would expire in-the-money. If the positions were not closed before expiration, all four options would be exercised and cancel out, and the original debit would be lost.
The payoff diagram of a long put butterfly defines the maximum risk and reward. The maximum loss on the trade is defined at entry by the combined cost of the four put options and is realized if the underlying stock price closes above or below the long options at expiration. The profit potential is limited to the width of the spread between the higher long put option and the two short put options, minus the debit paid to enter the position.
For example, assume a put butterfly is centered at $100 with two short put options, and long put options are purchased at $110 and $90. If the cost to enter the position is $5.00, that is the maximum loss that can be realized. If the stock is at $100 at expiration, the two short put options would expire worthless, and the $110 long put option would be in-the-money by $10.00. After subtracting the original debit of $5.00, the strategy would experience the maximum profit potential of $500.
If the stock price is below $100 at expiration but still within the protective “wing” of the long put, both of the short options would be in-the-money and still have value. The in-the-money short options would need to be repurchased. The difference between buying back the short options, selling the higher strike put option with value remaining, and the original debit paid would equal the trade’s profit or loss.
If the stock price is above $100 at expiration, the short puts and lower long put will expire worthless, and the higher long put would need to be closed. The credit received for selling the put option, minus the debit originally paid, would equal the profit or loss on the trade.
The strategy will break even at expiration if the underlying stock price is above or below the long options by the amount of the premium paid. In the above example, the downside break-even would be $95 ($90 lower strike + $5.00 net debit) and the upside break-even would be $105 ($110 higher strike price - $5.00 net debit).
A put butterfly is created by selling-to-open (STO) two put options at the same strike price and buying-to-open (BTO) long put options above and below the short put options. All four legs of a put butterfly have the same expiration date. The short puts do not need to be sold at the money. However, the short puts are sold at a strike price the investor believes the stock will be at expiration. The closer the stock price is to the short put contracts at expiration, the more profit will be realized.
Centering a put butterfly below the current strike price creates a bearish bias because the stock price will need to decline for the position to reach its max profit potential. Conversely, centering a put butterfly above the current strike price creates a bullish bias. The stock price would need to increase for the position to reach its maximum profit potential.
A put butterfly will experience its maximum profit potential if the stock price is exactly the same as the short strike options at expiration. In this scenario, the short put options will expire worthless, and the long put option that is in-the-money may be sold. The width of the spread, minus the debit paid, will result in a profit.
If the stock price is below the short put options at expiration, but still within the protective “wing” of the long put, both of the short options would be in-the-money and still have value. The in-the-money short options would need to be repurchased. The difference between buying back the short options, selling the higher put option with value remaining, and the original debit paid would equal the trade’s profit or loss.
If the stock price is above the short options at expiration, the short puts and lower long put will expire worthless, and the higher long put would need to be closed. The credit received for selling the put option, minus the debit originally paid, would equal the profit or loss on the trade.
Despite being net long for the strategy, time decay, or theta, works in the advantage of the put butterfly. Every day the time value of an options contract decreases, which will help to lower the value of the two short puts. Ideally, the underlying stock experiences minimal movement, and theta will exponentially lose value as the strategy approaches expiration. Suppose the long put is exited before expiration. In that case, the decline in time value may allow the investor to purchase the options contracts for less money than initially sold, while the in-the-money put option will retain its intrinsic value.
Put butterflies benefit from a decrease in the value of implied volatility. Lower implied volatility results in lower option premium prices. Ideally, when a put butterfly is initiated, implied volatility is higher than where it will be at exit or expiration. Lower implied volatility will help to decrease the value of the two short put options more rapidly. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the short options.
Put butterflies may be adjusted before expiration to extend the trade duration or rebalance the short strikes if the underlying stock price has moved away from the profit zone. Because put butterflies are net debit strategies, adjustments will most likely come with additional cost to the position, which will increase the risk, lower the profit potential, and narrow the break-even points. Furthermore, because put butterflies consist of two short contracts, assignment is a risk any time before expiration.
External factors, such as dividends, may need to be considered when deciding to adjust or close a put butterfly position. If an investor wants to avoid assignment risk, and/or needs to extend the trade into the future to allow the strategy more time to become profitable, the entire position can be closed and reopened at a future expiration date with the same strike prices or new positions.
Put butterflies require the underlying stock price to be at or near a specific price at expiration. If the position is not profitable and an investor wishes to extend the length of the trade, the put butterfly may be closed and reopened for a future expiration date. Because more time equates to higher options prices, the rollout will typically cost money and add risk to the position. If the stock price has moved away from the short put options, there may be an opportunity to close the existing position and reopen a new put butterfly with new strike prices closer to the underlying asset’s current price. However, doing so would not make sense if the new net debit paid exceeds the spread's width, as the position could no longer be profitable.
It is difficult to hedge long put butterfly positions because the strategy relies on a specific price target to be profitable. Because the strategy is entered with limited risk by its structure, follow-up action in the form of a hedge is often unnecessary. Long put options are purchased to provide protection against significant moves from the underlying asset. Therefore, the risk is strictly defined at trade entry.
A put broken-wing butterfly is similar to the long put butterfly in structure, with slight variations. Put broken-wing butterflies consist of buying one in-the-money long put, selling two out-of-the-money short puts, and buying one out-of-the-money long put below the short puts. Put broken-wing butterflies are still a bear put spread and bull put spread centered at the same strike price. However, the out-of-the-money long put option below the short strikes is not equal distance from the out-of-the-money long put option above the short strikes.
When purchasing the long put option below the short puts, at-least one strike price is skipped, thus creating a “broken-wing.” Because of this, the strategy typically receives a net credit at entry. Put broken-wing butterflies are slightly bearish and, like put butterflies, are positively impacted by time decay and decreasing volatility.
An ideal scenario would be for the underlying stock price to close at the short strike prices at expiration. However, if opened for a credit, no price movement or an increase in price would still result in a profit.
The maximum profit potential is the original credit received plus the width of the bear put spread, and is realized if the stock closes at the short put options. The maximum risk is the width of the spread above the short strikes, minus the credit received. The break-even price is the skipped strike price minus the credit received.
For example, if a stock is trading at $102 and an investor believes it will decrease some, but not a lot, a put broken-wing butterfly may be entered by purchasing a $105 long put, selling two puts at $100, and buying a long put at $90. If the trade collects $1.00 of credit, the maximum profit would be $600 if the stock closed at $100 at expiration because the long put would have $5.00 of intrinsic value, plus the initial credit received. The short puts and out-of-the-money long put would expire worthless. The maximum risk is -$400 if the stock closes at or below $90. If the stock is at $90, for example, the $105 long put would have $15 of intrinsic value, but the two short puts would each be $10 in-the-money ($15-$20+$1 credit received = -$4). The break-even price is $94 because the $105 put would have $11 of intrinsic value, but the short puts would each be $6.00 in-the-money, plus the $1.00 credit received. If the stock were to rise above the long put at $105, all options would expire worthless, and the initial $1.00 credit would remain as profit.