Long Put Butterfly

 

Description

         

The Long Put Butterfly is another rangebound strategy and is the opposite of a Short Put Butterfly, which is a volatility strategy. Long butterflies are quite popular

because they offer a good risk/reward ratio, together with low cost. The long

options at the outside strikes ensure that the risk is capped on both sides, and this is a much more conservative strategy than the Short Straddle.

 

The Long Put Butterfly involves a low strike long put, two ATM short puts, and an ITM long put. The resulting position is profitable in the event of rangebound action by the stock. Although the risk/reward ratio is attractive, the problem is that the maximum reward is restricted to the scenario where the stock is at the middle strike at expiration.

 

Market Opinion

 

Directional neutral. You expect little movement in the stock price.

 

P/L

 

 

 

 

 

 

 

 

When To Use

 

Use this sideways strategy for capital gain, when you want to accomplish this a low cost and where maximum profits occur when the stock finishes at the middle strike at expiration.

 

Example

 

XXXX is trading at $50 on May 14, 2011.

Buy June 2011 45 strike put for $0.98.

Sell two June 2011 50 strike puts at $2.91.

 

Net debit: premiums bought minus premiums sold: $1.28.

 

Benefit

 

The benefit here is that you can realize a capital gain for little cost and capped risk.

 

Risk vs. Reward

 

The risk is the net debit of the sold and bought options. The reward is the difference between adjacent strike prices minus the net debit.

 

Net Upside

 

Difference between adjacent strikes minus net debit.

 

Net Downside

 

Net debit paid.

 

Break Even Point

 

Break even up: higher strike minus net debit.

 

Break even down: lower strike plus net debit.

 

Effect Of Volatility

 

Low volatility is needed for this position.

 

Effect Of Time Decay

 

Positive when the position is profitable, negative when not profitable.

Alternatives Before Expiration

 

If the stock moves outside of your stop loss, below or above the stock price, close out the position.

 

Alternatives After Expiration

 

Just before expiration, close out the position.