Introduction
The Short Put Butterfly Spread is an advanced options trading strategy designed for traders who expect a rise in market volatility. Unlike the Long Put Butterfly, which profits when the underlying asset remains near a certain strike price, the Short Put Butterfly benefits when the price moves significantly in either direction.
In this blog, we will explore the Short Put Butterfly Spread, how it works, its advantages and risks, and how to implement it using Algomojo.
What is a Short Put Butterfly Spread?
A Short Put Butterfly Spread is a neutral strategy that involves selling a long put butterfly. The strategy profits when the price of the underlying asset moves significantly away from the middle strike price.
Structure of a Short Put Butterfly Spread
This strategy consists of three different strike prices and four put options:
- Sell 1 lower strike put option (OTM)
- Buy 2 at-the-money put options (ATM)
- Sell 1 higher strike put option (ITM)
This setup ensures that the maximum profit is achieved when the underlying asset moves significantly away from the middle strike price at expiration.
Example of a Short Put Butterfly Spread
Assume Stock XYZ is trading at ₹100, and you enter the following trades:
- Sell 1 put option at ₹95 (OTM)
- Buy 2 put options at ₹100 (ATM)
- Sell 1 put option at ₹105 (ITM)
If XYZ moves significantly above or below ₹100 at expiration, you achieve maximum profit since the short puts at the extremes gain value while the long puts remain relatively stable.
Key Takeaways
✅ High Volatility Strategy: Works best when the market is expected to move significantly.
✅ Limited Risk: The maximum loss is predefined at entry.
✅ Profit Potential: Profits when the price moves away from the middle strike price.
✅ Neutral to Volatile Markets: The strategy benefits from big price movements in either direction.
Payoff Structure of a Short Put Butterfly Spread
- Maximum Profit: Occurs when the underlying price is significantly away from the middle strike price at expiration.
- Maximum Loss: Occurs if the underlying price remains near the middle strike price.
- Break-even Points: There are two break-even levels:
- Lower Break-even = Lower Strike – Net Premium Received
- Upper Break-even = Higher Strike + Net Premium Received
Advantages of a Short Put Butterfly Spread
✅ Lower Capital Requirement: Requires less margin compared to naked options.
✅ Defined Risk and Reward: Maximum loss is limited to the net premium paid.
✅ Profits from Volatility: Ideal for traders who expect significant price swings.
Risks and Considerations
⚠️ Limited Profit Potential: The strategy works best in volatile markets but has a cap on maximum profit.
⚠️ Time Decay Impact: Since this is a short butterfly, time decay works against the position.
⚠️ Liquidity Concerns: Entry and exit spreads can widen in low-volume markets.
Step-by-Step Implementation in Algomojo
With Algomojo, traders can efficiently execute a Short Put Butterfly Spread. Here’s how:
1. Sell a Lower Strike Put (OTM)
- Path: My Strategy => New Strategy
- Select an out-of-the-money (OTM) put option to sell.
2. Buy Two At-the-Money Puts (ATM)
- Path: My Strategy => New Strategy
- Select an at-the-money (ATM) put option and buy two contracts.
3. Sell a Higher Strike Put (ITM)
- Path: My Strategy => New Strategy
- Select an in-the-money (ITM) put option to sell.
4. Group Your Strategy
- Path: My Group Strategy => New Group Strategy
- Combine the three legs into a single strategy group.
5. Enable Paper Trade Mode
- Path: My Group Strategy
- Test the strategy before executing it live.
6. Generate a SELL Signal to Open the Trade
- Path: My Group Strategy
- Execute a SELL signal to enter the Short Put Butterfly Spread.
7. Executed Paper Trade Orders
- Path: My Group Signals => Orders
- Ensure all contracts have been filled at your intended strike and expiration.
8. Monitor Open Positions
- Path: My Group Signals => Positions
- Track the market movements relative to your break-even points.
9. Generate a BUY Signal to Exit the Trade
- Path: My Group Strategy
- Close the trade if the price remains near the middle strike price to prevent losses.
10. Confirm Closing Orders
- Path: My Group Signals => Orders
- Ensure all contracts have been closed properly.
11. Review Trade Performance
- Path: My Group Signals => Positions
- Evaluate the profit/loss and assess market conditions.
Frequently Asked Questions (FAQ)
1. Is a Short Put Butterfly better than a Long Put Butterfly?
- Yes, if you expect high volatility. A Short Put Butterfly profits when the price moves significantly.
2. What happens if the stock remains near the middle strike price?
- The maximum loss is incurred when the price does not move significantly.
3. Can I use Call Options for a Short Butterfly Spread?
- Yes, a Short Call Butterfly follows the same structure using call options.
4. Does this strategy work in low volatility markets?
- No, it is designed for markets with high expected volatility.
5. Can I execute this strategy manually?
- Yes, but using Algomojo automates execution and reduces errors.
Final Thoughts
The Short Put Butterfly Spread is an effective strategy for traders expecting significant price movement. With Algomojo, traders can easily execute, monitor, and optimize this strategy using automated order placement and real-time tracking.
📢 Have you tried a Short Put Butterfly Spread? Share your experience in the comments!