Modified Put Butterfly

Modified Put Butterfly

Post By - Laxmi Mahera
Review By : Rohan Sharma
Updated on : October 26, 2021

Basics Concepts - Modified Put Butterfly

Description – Modified Put Butterfly

The Modified Put Butterfly is identical to the Long put Butterfly with the exception that the distance between the middle and Lower strike puts is closer than that of the higher and middle strikes .
The net effect of this is that the position changes to a range bound strategy with a bearish bias.
The Modified Put Butterfly involves a low strike long put, two ATM short puts, and an OTM long put.
The resulting position is profitable in the event of range bound or falling action by the stock.
Risk/reward ratio is attractive, the problem remains that the maximum reward is restricted to the scenario where the stock is at the middle strike at expiration.
Buy one lower strike (OTM) put.
Sell two middle strike (ATM) puts.
Buy one higher strike (ITM) put.
All options share the same expiration date for this strategy.
For this strategy, you must use all puts.
Remember that the distance between the lower and middle strikes is closer than the distance between the higher and middle strikes.
The maximum reward occurs if the stock is at the middle strike at expiration.

Steps to Trading a Modified Put Butterfly

Steps In

Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily Volume (ADV).
Try to ensure that the trend is range bound and identify a clear area of support.

Steps Out

Manage your position according to the rules defined in your Trading Plan.
If the stock falls below your stop loss below the current stock price, then unravel the entire position.
You can unravel the position just before expiration—remember to include all the commissions in your calculations.

Context - Modified Put Butterfly

Outlook

With modified butterflies, your profile is direction neutral to
moderately bearish—you expect a moderate rise.

Rationale

With modified butterflies, you are looking to execute a potentially
high yielding trade at very low cost, where your maximum profits
occur if the stock finishes at the middle strike price at expiration.
You are anticipating moderately low volatility in the stock price.

Net Position

This is a net debit trade, although the net cost is
typically low.
Your maximum risk is the net debit of the bought and
sold options.
Your maximum reward is the difference between
adjacent strike prices less the net debit.

Effect of Time Decay

Time decay is helpful to this position when it is profitable and
harmful when the position is unprofitable.
When you enter the trade, typically the stock price will be in the
profitable area of the risk profile, so from that perspective, time
decay harms the position.

Time Period to Trade

Month or Less

Breakeven [Lower strike + max risk]

Exiting the Trade - Modified Put Butterfly

Exiting the Position

With this strategy, you can simply unravel the spread by buying back the options you sold and selling the options you bought in the first place.
Advanced traders may leg up and down or only partially unravel the spread as the underlying asset fluctuates up and down.

Mitigating a Loss

Unravel the trade as described previously.
Advanced traders may choose to only partially unravel the spread leg-by-leg and create alternative risk profiles.

Advantages and Disadvantages

Advantages

Profit from a range bound stock for very little cost.
Capped and low risk.
Comparatively high risk/reward ratio if the stock remains range bound.

Disadvantages

The higher profit potential comes with a narrow range between the wing strikes.
The higher profit potential only comes nearer expiration.
Bid/Ask Spread can adversely affect the quality of the trade.

Share this Content

Derivatives Analysis

Advanced Option Strategy