Long Put Butterfly: Theory and Real-Life Trading Example [Overview]

One of the many ways to make money with options is to build a strategy that gives you a profit from a range-bound market. The put butterfly, also known as long put butterfly (or simply "put fly"), uses a butterfly spread with puts to offer cost-effective trading with minimal risk and defined financial exposure.

Key takeaways

• The long put butterfly is an options strategy designed to profit when the price of an asset doesn’t move too much. It uses a simple combination of multiple option contracts to make this happen.
• Its cost-effectiveness is highlighted by minimal initial investment and defined risk, offering a reduced financial exposure compared to many other strategies.

What Is the Long Put Butterfly?

The long put butterfly is an options strategy designed to capitalize on minimal price movement in an asset by using a multi-leg setup. This setup allows traders to profit from market conditions where significant price jumps are unlikely, offering potential gains while keeping risks in check.

How to Build a Long Put Butterfly

To build this strategy, follow these steps:

• Buy a Put: Start by purchasing one put option at a lower strike price.
• Sell Two Puts: Sell two put options at a middle strike price, which is closer to the asset's current market price.
• Buy Another Put: Finally, buy one more put option at a higher strike price.

This configuration, known as a butterfly spread with puts, creates a strategy where the potential for profit is maximized at the strike price of the two sold puts.

Understanding the P&L of a Long Put Butterfly

The profit and loss (P&L) diagram for a long put butterfly looks like this:

Notice the peak in profits at the strike price of the two puts you sold. This strategy makes money when the underlying asset's price remains within a specific range, defined by the strike prices of the options involved. The risk of loss is capped on either side, meaning that even if the asset's price moves significantly, the maximum potential loss is limited to the initial cost of setting up the strategy.

Why Consider a Long Put Butterfly?

There are a few reasons why traders are attracted to this strategy:

• High Profit Potential: The strategy can offer a high profit ratio, particularly appealing when the price of the underlying asset is expected to stay range-bound.
• Capped Loss: With a defined maximum loss, traders can engage in this strategy knowing their financial exposure is limited, providing peace of mind.
• Cost-Effective: The initial investment required is relatively low compared to other options strategies, making it an attractive choice for traders looking to manage costs.

In summary, the long put butterfly offers a balanced mix of risk and reward, making it a compelling choice for traders seeking to profit from stable market conditions. By carefully selecting strike prices, traders can optimize their chances of success while keeping potential losses under control.

This strategy is particularly useful for those who anticipate minimal movement in the underlying asset, providing an efficient way to engage in options trading with a clear understanding of potential outcomes. And if you think you can say "this stock will likely hover around this price for a while," then selling two puts at this level while buying two more puts at levels further away offers a potential reward with limited risk.

Long Put Butterfly - An Example

Here’s an example of the long put butterfly for you. Before we start, consider this: usually, you’ll place the put butterfly below the stock price. That’s because the bid-ask spread of the OTM options is typically narrower, making it easier to trade.

For the sake of our example, however, we won’t focus on this usual case but will instead take a more straightforward, textbook approach.

Suppose you believe that NU Holdings Ltd (NU) will hover around $16.5 over the next few weeks, while the current trading price is $14.06. You might have reasons such as fundamental analysis suggesting $16.5 as a fair value, or spotting a Fibonacci level around that price. Whatever your analysis, let's assume this is your belief.

In this scenario, you may open a long put butterfly using these steps (as found on our screener for options trades):

• Buy a $13 Put: This will serve as the lower boundary of your strategy.
• Sell Two $16.5 Puts: These create the central peak of your profit potential.
• Buy a $20 Put: This establishes the upper limit of your position.

All options would expire in three weeks. Notice that the P&L graph of this long put butterfly would be the following:

At this setup, your profit would peak around $16.5, potentially reaching close to $350. Conversely, your maximum risk is limited to $10 if NU moves below $13.06 or above $19.93. For many traders, risking $10 for the chance of gaining $350 is an enticing proposition, showcasing the appeal of the long put butterfly strategy.

When employing this strategy, it’s wise to examine NU’s historical price chart:

In this case, you'll notice a support level at $13, where NU's price struggled to break down recently. Historically, $13 has also acted as a resistance when NU traded lower, suggesting that traders won't easily allow NU to fall below this mark without significant news (in fact, picking a company that is not likely to produce significant news soon might be a good idea). Therefore, if you consider all these factors, it's reasonable to assume that NU will trade above $13 at expiration, making the maximum loss scenario unlikely.

As for the other side of the trade, things get trickier. NU is quite far away from $20, and it may not be likely it will reach that level within three weeks. Of course, if you notice that NU gets dangerously close to $20, you can always choose to close the position before expiration.

The Points to Consider

• Support and Resistance Levels: Identifying these can guide you in setting appropriate strike prices.
• Market Announcements: Avoid companies with soon-to-be-announced critical news, as these can disrupt predictable market behavior.

Given these considerations, you might view this as a favorable trade setup. The long put butterfly, or put fly, is most effective when you expect limited movement around your central strike price. It leverages a butterfly spread with puts to offer appealing risk-reward dynamics. By carefully analyzing market conditions and historical data, this strategy can be a cost-effective way to engage in options trading, with clearly defined potential outcomes.

Pros and Cons Factors of the Long Put Butterfly

Here is a table with the main pros and cons of the put butterfly:

Pros

• Capped Loss Risk: The long put butterfly strategy limits your potential loss, providing a clear risk-reward balance that appeals to cautious traders.
• High Profit Potential: This strategy offers a favorable profit-to-risk ratio if the underlying asset stays near the middle strike price.
• Cost-Effective Entry: Due to its multi-leg structure with a net debit, the long put butterfly often requires a relatively small upfront investment compared to other strategies.

Cons

• Relatively Low Profit Probability: Achieving the maximum profit depends on the underlying asset staying near the middle strike price at expiration, which may not always be easy to predict.
• Time Decay Can Hurt: Unlike strategies benefiting from time decay, the long put butterfly can lose value if the price moves too far away from the profit zone as expiration approaches.
• Impact of Rising IV: An increase in implied volatility can reduce the effectiveness of this strategy, as higher premiums may complicate adjustments or exits.

What More Should You Know About the Put Fly?

The put butterfly strategy comes with a few practical considerations to keep in mind:

1. Better Below the Market: Put butterflies are typically more effective when structured below the current market price. This is because out-of-the-money (OTM) options tend to have narrower bid-ask spreads, making them easier and more cost-effective to execute. On the flip side, if you're structuring a butterfly above the current price, or have a more neutral-to-bullish outlook, you might consider using a call-based variation like the long call butterfly.
2. Close Early for a Profit: You don’t have to wait for expiration to close your position. If the price of the underlying asset moves closer to your middle strike and time decay works in your favor, you can lock in profits early by closing the position. If you compare it to what we told you earlier, you can see that, for this strategy, time decay can sometimes work in favor and against the trader.
3. High Profit, Low Probability: While the long put butterfly offers a high profit ratio, this comes at the cost of a lower probability of achieving the maximum profit. Success depends on accurately predicting that the asset will hover near your central strike price at expiration.
4. Other Considerations: Monitor implied volatility carefully—it can affect the value of your position. Also, consider that some assets are prone to significant news events from time to time. For instance, a pharmaceutical company may have a clinical trial deadline to meet, a big tech company may launch a new product on the market, and so on. These companies may face strong price volatility during such events, so ask yourself: “Is my long put butterfly profit ratio so large that I can keep my position open during these periods, or is it better to look for a different trade opportunity?” The answer is not trivial, so keep this aspect in mind.

By considering these factors, you can better evaluate when and how to use the long put butterfly effectively.