Short Butterfly Explained

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Short Butterfly

The short butterfly is a neutral strategy like the long butterfly but bullish on volatility. It is a limited profit, limited risk options trading strategy. There are 3 striking prices involved in a short butterfly spread and it can be constructed using calls or puts.

Short Butterfly Construction
Sell 1 ITM Call
Buy 2 ATM Calls
Sell 1 OTM Call

Short Call Butterfly

Using calls, the short butterfly can be constructed by writing one lower striking in-the-money call, buying two at-the-money calls and writing another higher striking out-of-the-money call, giving the trader a net credit to enter the position.

Limited Profit

Maximum profit for the short butterfly is obtained when the underlying stock price rally pass the higher strike price or drops below the lower strike price at expiration.

If the stock ends up at the lower striking price, all the options expire worthless and the short butterfly trader keeps the initial credit taken when entering the position.

However, if the stock price at expiry is equal to the higher strike price, the higher striking call expires worthless while the “profits” of the two long calls owned is canceled out by the “loss” incurred from shorting the lower striking call. Hence, the maximum profit is still only the initial credit taken.

The formula for calculating maximum profit is given below:

  • Max Profit = Net Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying = Strike Price of Higher Strike Short Call

Limited Risk

Maximum loss for the short butterfly is incurred when the stock price of the underlying stock remains unchange at expiration. At this price, only the lower striking call which was shorted expires in-the-money. The trader will have to buy back the call at its intrinsic value.

The formula for calculating maximum loss is given below:

  • Max Loss = Strike Price of Long Call – Strike Price of Lower Strike Short Call – Net Premium Received + Commissions Paid
  • Max Loss Occurs When Price of Underlying = Strike Price of Long Calls

Breakeven Point(s)

There are 2 break-even points for the short butterfly position. The breakeven points can be calculated using the following formulae.

  • Upper Breakeven Point = Strike Price of Highest Strike Short Call – Net Premium Received
  • Lower Breakeven Point = Strike Price of Lowest Strike Short Call + Net Premium Received

Example

Suppose XYZ stock is trading at $40 in June. An options trader executes a short call butterfly strategy by writing a JUL 30 call for $1100, buying two JUL 40 calls for $400 each and writing another JUL 50 call for $100. The net credit taken to enter the position is $400, which is also his maximum possible profit.

On expiration in July, XYZ stock has dropped to $30. All the options expire worthless and the short butterfly trader gets to keep the entire initial credit taken of $400 as profit. This is also the maximum profit attainable and is also obtained even if the stock had instead rallied to $50 or beyond.

On the downside, should the stock price remains at $40 at expiration, maximum loss will be incurred. At this price, all except the lower striking call expires worthless. The lower striking call sold short would have a value of $1000 and needs to be bought back. Subtracting the initial credit of $400 taken, the net loss (maximum) is equal to $600.

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Note: While we have covered the use of this strategy with reference to stock options, the short butterfly is equally applicable using ETF options, index options as well as options on futures.

Commissions

Commission charges can make a significant impact to overall profit or loss when implementing option spreads strategies. Their effect is even more pronounced for the short butterfly as there are 4 legs involved in this trade compared to simpler strategies like the vertical spreads which have only 2 legs.

If you make multi-legged options trades frequently, you should check out the brokerage firm OptionsHouse.com where they charge a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the short butterfly in that they are also high volatility strategies that have limited profit potential and limited risk.

Short Put Butterfly

The short put butterfly is a neutral strategy like the long put butterfly but bullish on volatility. It is a limited profit, limited risk options strategy. There are 3 striking prices involved in a short put butterfly and it can be constructed by writing one lower striking out-of-the-money put, buying two at-the-money puts and writing another higher striking in-the-money put, giving the options trader a net credit to put on the trade.

Short Put Butterfly Construction
Sell 1 ITM Put
Buy 2 ATM Puts
Sell 1 OTM Put

Limited Profit

Maximum profit is attained for the short put butterfly when the underlying stock price rally pass the higher strike price or drops below the lower strike price at expiration.

If the stock ends up at the higher striking price, all the put options expire worthless and the short put butterfly trader keeps the initial credit taken when entering the trade.

If, instead, the stock price at expiry is equal to the lower strike price, the lower striking put option expires worthless while the “profits” of the remaining long put is canceled out by the “loss” incurred from shorting the higher strike put. So the maximum profit is still only the initial credit taken.

The formula for calculating maximum profit is given below:

  • Max Profit = Net Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying = Strike Price of Higher Strike Short Put

Limited Risk

Maximum loss for the short put butterfly is incurred when the price of the underlying asset remains unchanged at expiration. At this price, only the higher striking put which was shorted expires in-the-money. The trader will have to buy back that put option at its intrinsic value to exit the trade.

The formula for calculating maximum loss is given below:

  • Max Loss = Strike Price of Higher Strike Short Put – Strike Price of Long Put – Net Premium Received + Commissions Paid
  • Max Loss Occurs When Price of Underlying = Strike Price of Long Put

Breakeven Point(s)

There are 2 break-even points for the short put butterfly position. The breakeven points can be calculated using the following formulae.

  • Upper Breakeven Point = Strike Price of Highest Strike Short Put – Net Premium Received
  • Lower Breakeven Point = Strike Price of Lowest Strike Short Put + Net Premium Received

Example

Suppose XYZ stock is trading at $40 in June. An options trader executes a short put butterfly by writing a JUL 30 put for $100, buying two JUL 40 puts for $400 each and writing another JUL 50 put for $1100. The net credit taken to enter the position is $400, which is also his maximum possible profit.

On expiration in July, XYZ stock has dropped to $30. All the options expire worthless and the short put butterfly trader gets to keep the entire initial credit taken of $400 as profit. This is also the maximum profit attainable and is also obtained even if the stock had instead rallied to $50 or beyond.

On the downside, should the stock price remains at $40 at expiration, maximum loss will be incurred. At this price, all except the higher striking put expires worthless. The higher striking put sold short would have a value of $1000 and needs to be bought back to close the trade. Subtracting the initial credit of $400 taken, the net loss (maximum) is equal to $600.

Note: While we have covered the use of this strategy with reference to stock options, the short put butterfly is equally applicable using ETF options, index options as well as options on futures.

Commissions

Commission charges can make a significant impact to overall profit or loss when implementing option spreads strategies. Their effect is even more pronounced for the short put butterfly as there are 4 legs involved in this trade compared to simpler strategies like the vertical spreads which have only 2 legs.

If you make multi-legged options trades frequently, you should check out the brokerage firm OptionsHouse.com where they charge a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the short put butterfly in that they are also high volatility strategies that have limited profit potential and limited risk.

Short Broken Butterfly Explained (Simple Guide)

How would you like to profit from a stock that you think will rise significantly in the short term while limiting your loss if it tanks? If so, then you should check out the short broken butterfly options strategy.

As the name implies, a short broken butterfly (or short skip-strike butterfly) is based on the iron butterfly strategy. But there’s a crucial difference.

The long iron butterfly is a profitable trade when the underlying stock moves significantly higher or lower. The short iron butterfly is profitable when the stock stays neutral.

With a short broken butterfly, though, you’ll only profit if the stock moves in one direction.

In this guide, we’ll explain the short broken butterfly strategy so you can determine if it’s right for you.

What Is a Short Broken Butterfly ?

A short broken butterfly is a multi-leg options strategy that involves four legs with three strike prices. It’s among various “iron butterfly” choices for options traders.

First, you sell a call option at the highest strike price.

Then, you buy two call options at the middle strike price.

Finally, you sell a call option at the lowest strike price.

The distance between the lowest and middle strike prices is half the distance between the highest and middle strike prices.

For example, if the lowest strike price is 85 and the middle strike price is 90, then the highest strike price is 100.

The difference between 85 and 90 is 5. The difference between 100 and 90 is 10, or twice the first difference.

As you can see from that example, the strike price of 95 is “skipped.” That’s why some people call the short broken wing butterfly a short skip-strike butterfly.

You can also place a short broken wing butterfly order with put options instead of call options. Just follow the same rules except that you skip the strike price in the lower half of the trade.

In the example above, you’d sell a put option with a strike price of 85, then buy two put options with a strike price of 95, and finally sell another put option with a strike price of 100.

Keep in mind: when you place a short broken butterfly with call options, you’ll profit when the price of the underlying stock rises significantly. When you place a short broken butterfly with put options, you’ll profit when the price of the underlying stock drops significantly.

In either case, you’ll lose money if the stock closes around the strike price of the long positions at expiration. The following video provides details:

When Would You Use a Short Broken Butterfly ?

Use a short broken butterfly with call options when you’re bullish on a stock. Use a short broken wing butterfly with put options when you’re bearish on a stock.

Your target price for the stock should be the highest strike price if you’re using call options or the lowest strike price if you’re using put options.

The value of a short broken wing butterfly trade rises and falls with implied volatility (IV). That’s why it’s often a great strategy if you think IV will rise in the near future.

On the other hand, if IV falls, expect to see your money go down the drain.

How Does a Short Broken Butterfly Work?

First, make sure that your trading platform supports multi-leg orders. As I mentioned above, there are four legs involved in a short broken butterfly strategy.

Next, find a stock that you think will move significantly in the near future. Start looking at its options chains.

Find an options contract with a strike price that’s right around your target price for the stock. Remember: look at call options if you expect the stock price to rise and look at put options if you expect the stock price to fall.

Once you’ve done that, identify the other options for the trade.

If you’re using call options, look for contracts with lower strike prices. If you’re using put options, look for contracts with higher strike prices.

Remember: the difference between the lower strike and the middle strike is not the same as the difference between the higher strike and the middle strike.

If you’re using call options, the difference in the higher range should be twice the difference in the lower range.

If you’re using put options, the difference in the lower range should be twice the difference in the higher range.

The expiration dates of all the contracts should be the same, though.

The current price of the stock should be around the lowest strike price if you’re using call options or the highest strike price if you’re using put options.

Real Life Example Using a Short Broken Butterfly

Let’s say that drug giant Bristol-Myers Squibb (NYSE: BMS) is trading at $47 per share right now. You think it’s oversold and will rise significantly in the near future so you’d like to make some money with a short broken butterfly.

You check out next month’s options contracts. Your price target is $53; that’s where you start your search.

The call option for that strike price is currently bid at $1.86. Upon further research, you find that the stock has relatively low implied volatility so it looks like a good trade.

That $53 strike, by the way, will be the highest strike price in the trade. That’s because it’s your target price.

Next, you need to find options contracts with lower strike prices.

The options contract with a strike price at $49 is offered at $1.30. You’ll buy two of those options.

Finally, the at-the-money options contract (where the strike price is the same as the current stock price of $47) is bid at $1.86. That’s the lower end of the trade.

This is a good short broken butterfly with call options because the difference between the two lower legs is half the distance between the two upper legs.

The strike prices on the lower legs are $102 and $104. That’s a difference of $2.

The strike prices on the upper legs are $104 and $108. That’s a difference of $4.

Now, let’s go through the whole trade.

You start by selling the option with the highest strike for $0.31 Remember, though, that options contracts are sold in batches of 100 shares each so it earns you $31 ($0.31 x 100 = $31).

Next, you buy two call options at the middle strike price. That costs you $260 ($1.30 x 2 x 100 = $260).

Finally, you sell the call option at the lowest strike price. That earns you $186 ($1.86 x 100 = $186).

If you do the math, you’ll see that the trade costs you $43 ($260 – $186 – $31 = $43).

Let’s say that your prediction comes true and BMS trades at just below $53 when the contracts expire. What happens then?

The two options you bought will be worth around $4.00 each, or $800 total ($4.00 x 2 x 100 = $800). So you make a profit of $540 on that part of the trade ($800 – $260 = $540).

The $53 call option that you sold will expire worthless. You keep all $31 you earned from selling it.

The $47 call option is now worth $6.00. You buy it back for $600, taking a realized loss of $414 ($600 – $186 = $414).

That means your total profit for the whole butterfly is $157 ($540 + $31 – $414 = $345).

Congratulations! You earned a positive return on the trade!

Here are a few options strategies similar to a short broken butterfly:

  • Iron Butterfly – Similar to a broken wing butterfly but without the broken wing. It’s also profitable when the underlying stock stays within a price range (short) or busts out of the price range in either direction (long).
  • Long Broken Wing Butterfly – Very similar to a short broken wing butterfly except that it’s got a bullish outlook.

Short Broken Butterfly Compared to Other Options Strategies

Unlike many other options strategies, a rise in implied volatility works in your favor with a short broken butterfly. That’s why it’s best to place the trade when IV is relatively low.

Also, if you’re completely wrong and the stock moves wildly in the opposite direction of your target price, the risk is minimal. The maximum risk for a short broken butterfly is realized when the stock closes at the middle strike price at expiration.

You can be really wrong with a short broken butterfly with a minimal loss. You just can’t be a little bit wrong or you’ll take a big hit.

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