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.