A short put butterfly is a neutral to slightly bullish options strategy that aims to profit from significant price movement in the underlying asset away from a central strike price by expiration. It’s the inverse of the long put butterfly, which profits from the price settling near the central strike.

Core Concept:

A short put butterfly is constructed by combining three put option contracts with the same expiration date but three different strike prices, all equidistant from each other. It involves:

1. Selling one put option with a higher strike price. This is the upper “wing” of the butterfly and generates premium.
2. Buying two put options with a middle strike price. This is the “body” of the butterfly and costs premium.
3. Selling one put option with a lower strike price. This is the lower “wing” of the butterfly and generates premium.

The middle strike price (where you buy two puts) is the point of maximum potential loss. The strategy profits when the price moves substantially above the higher strike or below the lower strike at expiration.

Construction Example:

Suppose the underlying asset is trading at $50. A typical short put butterfly might be constructed with the following options, all with the same expiration date and a $5 width between strikes:

• Sell 1 Put Option with a $55 strike price.
• Buy 2 Put Options with a $50 strike price.
• Sell 1 Put Option with a $45 strike price.

Net Credit (Typical) or Small Net Debit:

Establishing a short put butterfly typically results in a net credit because the premiums received from selling the outer put options are usually greater than the premium paid for buying the two middle put options. However, depending on the relative prices of the options, it can sometimes be established for a small net debit. This net credit (or small debit) is the maximum potential profit of the strategy.

Profit and Loss Profile:

The profit and loss diagram of a short put butterfly resembles an inverted peaked tent or a “V” shape, with the trough at the middle strike price.

• Maximum Potential Profit: The net credit received when establishing the spread (or, if a net debit, the maximum loss is limited to that debit, and the profit potential arises from the price moving away). Profit is realized if the price of the underlying asset expires at or above the higher strike price ($55) or at or below the lower strike price ($45). In these scenarios, the sold options expire worthless or offset the bought options, allowing you to keep the initial credit.
• Maximum Potential Loss: Limited and occurs when the price of the underlying asset expires exactly at the middle strike price ($50). At this point:
  • The $55 short put is $5 in-the-money.
  • The two $50 long puts are at-the-money (worth $0 intrinsic value at expiration).
  • The $45 short put is out-of-the-money (worth $0 intrinsic value at expiration). The maximum loss is the difference between the distance between the strikes (either $5) minus the initial net credit received (or plus the net debit paid). So, Maximum Loss = (Higher Strike – Middle Strike) – Net Credit (or + Net Debit).
• Breakeven Points: There are typically two breakeven points for a short put butterfly:
  • Lower Breakeven: Lower strike price plus the net credit. In our example, if the net credit was $1.50, the lower breakeven would be $45 + $1.50 = $46.50.
  • Upper Breakeven: Upper strike price minus the net credit. In our example, the upper breakeven would be $55 – $1.50 = $53.50.

The position is profitable if the underlying asset price expires below the lower breakeven or above the upper breakeven. Maximum loss occurs at the middle strike.

Why Use a Short Put Butterfly?

• Expectation of High Volatility/Significant Price Movement Away from a Specific Price: This strategy is ideal when an investor anticipates a sharp move in the underlying asset’s price but is uncertain about the direction. It aims to profit from a breakout from a defined range.
• Potential for Net Credit Upfront: Unlike the long put butterfly which requires an initial debit, the short put butterfly typically generates a net credit, providing immediate income.
• Defined Risk and Reward: Both the maximum potential profit (the net credit) and the maximum potential loss are known at the time the trade is entered.

Key Considerations:

• Time Decay (Theta): Time decay generally works in favor of a short put butterfly if the price moves significantly away from the middle strike. As expiration approaches, the value of all options decreases. If the outer short puts are out-of-the-money or the inner long puts are in-the-money, the net effect can be positive. However, if the price lingers near the middle strike, time decay can erode the initial credit.
• Volatility (Vega): An increase in implied volatility after the spread is established is generally beneficial for a short put butterfly, as it increases the value of the purchased middle put options more than the sold outer put options. Conversely, a decrease in implied volatility can be detrimental.
• Accuracy of Price Movement Prediction (Away from the Center): The strategy’s profitability depends on the underlying asset price moving significantly away from the middle strike price by expiration. If the price remains near the middle strike, the maximum loss is realized.
• Limited Profit Potential: The maximum profit is capped at the initial net credit received.

Managing a Short Put Butterfly:

• Monitoring Price Movement: Closely tracking the underlying asset’s price relative to the breakeven points is crucial as expiration approaches.
• Taking Profits Early: If the price moves significantly beyond one of the outer strikes, you might consider closing the position early to lock in the maximum profit.
• Rolling the Spread: If the price approaches the middle strike and maximum loss seems likely, you might consider “rolling” the spread by closing the existing positions and opening new ones with different strike prices or expiration dates, although this can be complex and may not always be advantageous.

Similar Strategies:

• Short Call Butterfly: Constructed with calls instead of puts, it has the same profit/loss profile but is used when a trader expects a significant price move away from a specific strike price, potentially upwards.
• Long Put Butterfly: The inverse strategy, profiting from minimal price movement around the middle strike.
• Short Iron Butterfly: A similar neutral strategy using both calls and puts, also established for a net credit and profiting from the price moving outside a specific range.

In Conclusion:

The short put butterfly is a volatility-based options strategy for traders who anticipate a significant price swing in the underlying asset but are uncertain about the direction. It offers a defined risk and a limited profit potential (the initial credit). The maximum profit is realized if the price moves beyond the breakeven points by expiration, while the maximum loss occurs if the price settles at the middle strike. Careful consideration of volatility and the likelihood of a substantial price move is essential when deploying this strategy.