You can think of this strategy as embedding a bull (short) put spread inside a long put butterfly spread. Essentially, you're selling the short put spread to help pay for the butterfly. Because establishing those spreads separately would entail both buying and selling a put with strike B, they cancel each other out and it becomes a dead strike.
The embedded short put spread makes it possible to establish this strategy for a net credit or a relatively small net debit. However, due to the addition of the short put spread, there is more risk than with a traditional butterfly.
A skip strike butterfly is more of a directional strategy than a standard butterfly. Ideally, you want the stock price to decrease somewhat, but not beyond strike C. In this case, the puts with strikes A and C will approach zero, but you’ll retain the premium for the put with strike D.
This strategy is usually run with the stock price at or around strike D. That helps manage the risk, because the stock will have to make a significant downward move before you encounter the maximum loss.
Maximum Potential Profit
Potential profit is limited to strike D minus strike C minus the net debit paid, or plus the net credit received.
Maximum Potential Loss
Risk is limited to the difference between strike A and strike B, minus the net credit received or plus the net debit paid.
Break-even at Expiration
If established for a net credit (as in the graph above) then the break-even point is strike B minus the net credit received when establishing the strategy.
If established for a net debit, then there are two break-even points:
- Strike D minus net debit paid.
- Strike B plus net debit paid.
TradeKing Margin Requirements
Margin requirement is equal to the difference between the strike prices of the short put spread embedded into this strategy.
NOTE: If established for a net credit, the proceeds may be applied to the initial margin requirement.
Keep in mind this requirement is on a per-unit basis. So don't forget to multiply by the total number of units when you’re doing the math.
As Time Goes By
For this strategy, time decay is your friend. Ideally, you want all options except the put with strike D to expire worthless.
After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.
If the stock is at or near strike C, you want volatility to decrease. Your main concern is the two options you sold at strike C. A decrease in implied volatility will cause those near-the-money options to decrease in value, thereby increasing the overall value of the butterfly. In addition, you want the stock price to remain stable around strike C, and a decrease in implied volatility suggests that may be the case.
If the stock price is approaching or outside strike D or A, in general you want volatility to increase. An increase in volatility will increase the value of the option you own at the near-the-money strike, while having less effect on the short options at strike C.