You can think of this strategy as simultaneously buying one long put spread with strikes D and B and selling two bear put spreads with strikes B and A. Because the long put spread skips over strike C, the distance between its strikes will be twice as wide as the strikes in the short put spread. In other words, if the width from strike D to strike B is 5.00, the width from strike B to strike A will be 2.50.
While a traditional butterfly with puts is often used as a neutral strategy, this strategy is usually run with a slightly bearish directional bias. To reach the sweet spot, the stock price needs to drop a bit.
Selling two short put spreads with half the width of the long put spread usually makes this strategy less expensive to run than a traditional butterfly with puts. The tradeoff is that you’re taking on more risk than you would with a traditional butterfly. If the stock continues to fall below strike B, your profit will decline at an accelerated rate and the trade could become a loser fairly quickly. That’s because you’re short two put spreads, and there’s half as much distance between strike B and strike A (short spreads) as there is between strike D and strike B (long spread).
Ideally, you want the options at strike A and B to expire worthless, while retaining maximum value for the long put at strike D.
Maximum Potential Profit
Potential profit is limited to strike D minus strike B minus the net debit paid.
Maximum Potential Loss
Risk is limited to the net debit paid.
Break-even at Expiration
There are two break-even points for this strategy:
- Strike D minus the net debit paid
- Strike A plus half the net debit paid
TradeKing Margin Requirements
After the trade is paid for, no additional margin is required.
As Time Goes By
For this strategy, time decay is your friend. Ideally, you want all of the 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 B, you want volatility to decrease. Your main concern is the three options you sold. 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 B, 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 B.