Tuesday, December 18, 2018
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Long Put Butterfly

long put butterfly

long put butterfly

the long put butterfly spread is a limited profit, limited risk options trading strategy that is taken when the options trader thinks that the  underlying security will not rise or fall much by expiration.

long put butterfly construction
buy 1 out the money put
sell 2 at the money puts
buyt 1 in the money put

there are 3 striking prices involved in a long put butterfly spread and it is constructed by buying one lower striking put, writing two at-the-money puts and buying another higher striking put for a net debit.

limited profit

maximum gain for the long put butterfly is attained when the underlying stock price remains unchanged at expiration. at this price, only the highest striking put expires in the money.

the formula for calculating maximum profit is given below:
  • max profit = strike price of higher strike long put - strike price of short put - net premium paid - commissions paid
  • max profit achieved when price of underlying = strike price of short put

long-butterfly

limited risk

maximum loss for the long put butterfly is limited to the initial debit taken to enter the trade plus commissions.

the formula for calculating maximum loss is given below:
  • max loss = net premium paid + commissions paid
  • max loss occurs when price of underlying = strike price of higher strike long put

breakeven point(s)

there are 2 break-even points for the long put butterfly position. the breakeven points can be calculated using the following formulae.
  • upper breakeven point = strike price of highest strike long put - net premium paid
  • lower breakeven point = strike price of lowest strike long put + net premium paid

example

suppose xyz stock is trading at $40 in june. an options trader executes a long put butterfly by buying a jul 30 put for $100, writing two jul 40 puts for $400 each and buying another jul 50 put for $1100. the net debit taken to enter the trade is $400, which is also his maximum possible loss.

on expiration in july, xyz stock is still trading at $40. the jul 40 puts and the jul 30 put expire worthless while the jul 50 put still has an intrinsic value of $1000. subtracting the initial debit of $400, the resulting profit is $600, which is also the maximum profit attainable.

maximum loss results when the stock is trading below $30 or above $50. at $50, all the options expires worthless. below $30, any "profit" from the two long puts will be neutralised by the "loss" from the two short puts. in both situations, the long put butterfly trader suffers maximum loss which is equal to the initial debit taken to enter the trade.

note: while we have covered the use of this strategy with reference to stock options, the long put butterfly is equally applicable using etf options, index options as well as options on futures.

commissions

for ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

however, for active traders, commissions can eat up a sizable portion of their profits in the long run. if you trade options actively, it is wise to look for a low commissions broker. traders who trade large number of contracts in each trade should check out optionshouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade).

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