Modified Put Butterfly

 

Description

 

The Modified Put Butterfly is identical to the Long Put Butterfly with the exception that the distance between the middle and higher strike calls is closer than that of the lower and middle strikes.

 

The net effect of this is that the position changes to a rangebound strategy with a bullish bias. As such, we make our biggest profits if the stock remains around the middle strike, but we can still make a profit if the stock breaks to the upside.

 

This is a fiddly strategy and should only be used if you have an analyzer handy otherwise, it would be easy to miscalculate your risk profile. But in terms of its usefulness, the Modified Butterfly is extremely useful for butterfly enthusiasts who need some flexibility.

 

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 rangebound or rising action by the stock. Although the 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.  

 

Market Outlook

 

Neutral to moderately bullish.

 

 

P/L Profile

 

 

 

 

 

 

 

When To Use

 

Use when you are expecting low volatility in the stock movement. You expect to receive a high yield from investing very little capital.

 

Example

 

XXXX is trading t $50.00 on May 9, 2011.

Buy the June 2011 45 strike put for $0.98.

Sell two June 2011 55 strike puts at $6.12.

Buy the June 2011 60 strike put for $10.28.

 

Benefit

 

For very little cost, profit from sideways to rising stock.

 

Risk vs. Reward

 

The risk is the difference between the low and middle strikes minus the difference between the middle and high strike plus net debit or minus net credit. There is a high risk compared to reward when the stock stays rangebound. The reward is the difference between the middle and high strikes plus the net credit or minus the net debit.

 

Net Upside

 

High minus middle strike price plus net credit.

 

Net Downside

 

Middle minus low strike plus net credit.

 

Break Even Point

 

Lower strike plus maximum risk.

 

Effect Of Volatility

 

Effect Of Time Decay

 

Positive when the position is profitable, negative when unprofitable.

 

Alternatives Before Expiration

 

If stock drops under the stop loss below the current stock price, you can close out the position.

 

Alternatives After Expiration

 

Close out the position by buying back the options sold and selling the options bought.