Long Butterfly Spread with Puts

Overview

Ever wanted to bet that a stock will stay exactly where it is? The Long Butterfly Spread is the options strategy equivalent of saying, "I don't think this stock is going anywhere exciting, and I'd like to profit from that prediction." It's like setting up a profit tent right over your target price.

Despite its elegant name, the butterfly is actually quite straightforward in concept: you buy one put at a lower strike, sell two puts at a middle strike, and buy one put at a higher strike – all with the same expiration date and typically with equal spacing between strikes. The result is a position that reaches maximum profitability when the stock price lands exactly on your middle strike at expiration. Think of it as placing a bullseye on the stock chart and aiming for a direct hit.

Key Characteristics

• Market Outlook: "I think this stock is going to sit still right around my target price"
• Risk: Limited to whatever you paid to set up the butterfly (usually a small amount)
• Profit Potential: Limited but potentially substantial relative to your investment
• Breakeven Points: Two of them – one a bit above and one a bit below your target price

When to Use

The Long Butterfly Spread might be your strategy of choice when:

• You have a very specific price target for a stock and strong conviction it will land there
• You expect a period of low volatility or a stock that's likely to trade sideways
• You want to profit from time decay without taking on too much risk
• You're looking for a strategy with a potentially high return on investment
• You want to take advantage of options that seem overpriced due to high implied volatility

Real-World Example

Let's walk through this with a concrete example. Say XYZ stock is trading at $50, and you have a strong conviction it will still be around $50 in a month.

• You buy 1 put at the $45 strike for $0.50 ($50 total)
• You sell 2 puts at the $50 strike for $2 each ($400 total)
• You buy 1 put at the $55 strike for $4.50 ($450 total)
• Your net cost is $100 for the whole position ($1 per share)

Now let's see what happens in different scenarios at expiration:

• Perfect scenario: XYZ closes exactly at $50. Your $45 put expires worthless, your two $50 puts expire worthless, and your $55 put is worth $5 ($500). You make a $400 profit on your $100 investment – that's a 400% return!
• Still good: XYZ closes at $48. Your $45 put expires worthless, your two $50 puts cost you $4 total, and your $55 put is worth $7. Your net is $3 profit ($300), still a nice 200% return.
• Breakeven: XYZ closes at $46 or $54. At these points, the value of your options package equals your initial $100 investment.
• Worst case: XYZ moves dramatically, closing at $45 or below, or $55 or above. All your options either expire worthless or cancel each other out, and you lose your entire $100 investment.

The beauty of the butterfly is that your maximum profit occurs when you're exactly right about the stock price, but you can still make money even if you're a little off. And your risk is always limited to your initial investment.

The Good Stuff

• Your risk is strictly limited to what you paid for the butterfly
• The potential return on investment can be impressive (often 3-5x your initial cost)
• Time decay works in your favor as expiration approaches
• You can profit even if your price prediction is slightly off
• It's cheaper than buying a straddle or strangle for a neutral outlook
• You can adjust the width between strikes to match your confidence level

The Not-So-Good Stuff

• You need to be pretty accurate with your price prediction for maximum profit
• The profit zone is relatively narrow – the stock can't move too far in either direction
• You're dealing with three different options, which means higher commission costs
• It can be tricky to get filled at good prices when entering or exiting the position
• The profit diagram looks like a mountain peak – great at the top but falls off quickly on both sides

Playing It Smart

• Choose your middle strike (target price) based on strong technical support/resistance levels
• Consider using wider spreads between strikes if you're less confident about the exact price target
• Look for opportunities when implied volatility is high but you expect it to decrease
• Don't wait until expiration if the stock hits your target price early – consider taking profits
• Avoid setting up butterflies right before major announcements or events
• Remember that the maximum profit only occurs at a single price point, so manage expectations
• Consider using put butterflies when implied volatility is higher for puts than calls