What is a long butterfly with puts?

A long butterfly with puts is a strategy where you sell-to-open two put options at the same strike price, and then buy-to-open long put options above and below the short put options. This will create four legs, all with the same expiration date.

Short put contracts do not need to be sold at the money. The trader sells the contract at a price they believe the stock will be at when it expires. The closer the stock price is to the contract when it expires, the more profit will be made.

Placing a long butterfly with puts below the current strike price creates a bearish bias because the underlying stock price would need to fall in order for the position to generate maximum profit.

A long butterfly with puts above the current strike price creates a bullish bias. If the price of the underlying increases, the position can make more money.

When to use a long butterfly with puts strategy

A long butterfly with puts is considered a market neutral strategy. This means that it doesn't have a bias in one direction or another.This is a type of strategy used when you expect the price of a stock to stay the same or very close to the current price before the options expire.

If the stock price goes up or down a lot, then this strategy is vulnerable to losses. 

How to manage a long butterfly with puts position

A long butterfly with puts benefits from time decay. Traders  want to see all the options in their position expire worthless, except the put with the highest strike price, and see the underlying stock trade at the middle strike.

When you put on this trade, the effect of implied volatility depends on how close the underlying stock is to your strike prices.

If you think the stock price is going to trade around the middle strike, you want volatility to go down. This will make your options that you sold at the middle strike less valuable, which will make the whole butterfly more valuable.

If your trade goes wrong and the stock price is getting closer to or going past the higher or lower strike prices, you want the volatility to increase, especially as the expiration date gets closer.

The more volatile the market is, the more valuable your option at the near-the-money strike will become. The volatility will have less of an effect on your options at the middle strike. This will make the overall value of your butterfly option go up.

Long butterfly with puts maximum profit potential

The potential profit for this trade is limited to strike middle minus the higher strike, minus the net debit paid to initiate the position. For the strategy to generate maximum profitability, the underlying stock price will need to close right at the short strike prices, at the time of expiration.

Long butterfly with puts maximum loss potential

When you enter a trade, the most money you can lose is the amount you paid to get into the position. If the stock price closes above or below the price of the long put options you bought, you will lose that maximum amount.