Long Put Butterfly is an options trading strategy that combines two vertical spreads – a long put spread and a short put spread. It involves buying a put option at a lower strike price, selling two put options at a middle strike price, and buying another put option at a higher strike price. The options have the same expiration date, and the strike prices are equidistant from each other.
The Long Put Butterfly strategy is a limited risk and limited reward strategy that can be used in a range-bound market, where an investor expects the underlying asset to remain within a specific price range. The strategy can be used in both bearish and bullish market conditions, depending on the direction of the middle strike price.
How does Long Put Butterfly work?
The Long Put Butterfly strategy involves buying and selling put options with different strike prices. Let’s assume an investor expects the underlying asset’s price to remain stable within a certain range. The investor can execute the Long Put Butterfly strategy by:
- Buying a put option with a strike price lower than the current market price of the underlying asset.
- Selling two put options with a strike price at the middle of the range.
- Buying a put option with a strike price higher than the current market price of the underlying asset.
The options should all have the same expiration date.
For example, let’s say that the current market price of XYZ stock is $100, and an investor believes the stock price will remain within a range of $90 to $110 over the next month. The investor can execute a Long Put Butterfly strategy by:
- Buying a put option with a strike price of $85.
- Selling two put options with a strike price of $100.
- Buying a put option with a strike price of $115.
The options would all expire in one month.
If the stock price remains within the range of $90 to $110 at expiration, the Long Put Butterfly strategy will result in a profit. The profit is limited, and it is equal to the difference between the middle strike price and the lower or higher strike price, minus the net cost of the options. If the stock price falls below the lower strike price or rises above the higher strike price, the strategy will result in a loss.
Advantages and disadvantages of Long Put Butterfly
Advantages:
- Limited risk: The maximum loss that can be incurred by the Long Put Butterfly strategy is the net cost of the options.
- Limited reward: The maximum profit that can be made by the Long Put Butterfly strategy is known in advance and is equal to the difference between the middle strike price and the lower or higher strike price, minus the net cost of the options.
- Versatility: The Long Put Butterfly strategy can be used in both bullish and bearish market conditions, depending on the direction of the middle strike price.
Disadvantages:
- Limited profit potential: The maximum profit that can be made by the Long Put Butterfly strategy is limited, and it may not be sufficient to justify the risk involved.
- Range-bound market required: The Long Put Butterfly strategy works best in a range-bound market, where the underlying asset’s price remains within a specific range.
- Complex strategy: The Long Put Butterfly strategy involves multiple options and strike prices, making it a complex strategy that requires careful analysis and monitoring.
Conclusion
The Long Put Butterfly strategy is a limited risk and limited reward strategy that can be used in a range-bound market, where an investor expects the underlying asset to remain within a specific price range. The strategy involves buying a put option at a lower strike price, selling two put options at a middle strike price, and buying another put option at a higher strike price. The options have the same expiration date, and the strike prices are equidistant from each other.
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