When to Apply the Bear Butterfly Spread
The bear butterfly spread should be considered when you expect that a security will fall in price within a certain period of time, and you have a good idea of what price it will fall to. It allows you to make a good return if your prediction is accurate, while only exposing you to a limited amount of risk.
The upfront cost is relatively low, so it's a good strategy if you have limited investment capital. The potential profits are limited though, so it isn't ideal if you believe that the price of the security could possibly fall substantially in price.
How to Apply the Bear Butterfly Spread
There are three transactions required to create a bear butterfly spread, but you must first decide roughly what price you expect the underlying security to fall to and by when. You would then write puts with the strike equal to your predicted price, and with the appropriate expiration date. In addition, for every two puts that you write you would buy one put with a higher strike and one with a lower strike. These options should have the same expiration date.
Ideally, you should use strikes that are as close as possible to each other. You should end up covering most of the cost of buying puts with the credit received for writing puts, resulting in a relatively small net debit.
You can follow the above instruction using calls instead, and the overall cost and potential profits will be roughly the same. It doesn’t make a huge amount of difference whether you use calls or puts, although the prices will sometimes be a little different so there may be an advantage one way or the other. In this article, we work on the premise of using put options.
Potential for Profits & Losses
The potential profits of the bear butterfly spread are limited, and you will make the maximum amount possible if (at the time of expiration) the underlying security has fallen in price to exactly the strike of the put options written.
This would result in the puts you have written expiring worthless, along with the purchased puts options with the lower strike. The other leg of the spread, the puts you bought with the higher strike, will expire in the money and you should be able to sell them for an amount that will cover the initial debit and return a profit on top of that.
The potential losses are also limited to the amount of the net debit paid at the time of applying the spread. You will incur the maximum loss if the underlying security goes up in price, or doesn't fall in price sufficiently for any of the options to be in the money. If they all expire worthless, then you have no further returns so will lose all of your initial investment.
You will also lose your initial investment if the price of the underlying security falls too much below the strike of the options with the lowest strike, because this will result in the liability of the puts written being roughly equal to the returns made from the ones purchased.
When you apply this strategy, you will create two break-even points: a higher break-even point and a lower break-even point. Basically, as long as the price of the underlying security is lower than the higher break-even point and higher than the lower break-even point you will make a profit.
The closer the price of the underlying security is to the middle strike (that of the put options written), the greater the profit will be. We have provided an example later, along with the calculations required to determine these break-even points.
Advantages & Disadvantages
If you can be reasonably accurate in predicting where the price of the underlying security will move to, then you can make a high return on your investment through using this strategy. The cost of the net debit is relatively low when compared to some other strategies, and yet the potential profits can be quite substantial.
You also know precisely how much money is at risk, becausethe maximum you can lose is limited to the cost of applying the spread. The flexibility means that you can attempt to profit from any particular price that you believe the underlying security will move to, regardless of whether you are expecting a large drop or a moderate one.
There are a couple of downsides too however. It does require an ability to make accurate predictions about how much the price of an underlying security will fall by, which isn't an easy thing to do. If you are good at predicting the direction of price movements, but not necessarily the size of those movements, then you will find it hard to consistently return profits using this strategy.
The fact that there are three transactions involved means that you will pay more in commissions than you would with strategies that involve fewer transactions.
Example
We have provided an example of the bear butterfly spread below, to give you an idea of how it can be used and what some of the possible results may be. The example uses hypothetical prices rather than real market data, and commissions haven't been included. We have also shown the calculations that can be used to work out the potential profits, losses, and break-even points.
Initial Trade
- Company X stock is trading at $50, and you believe it will fall to around $47.
- Puts on Company X stock with a strike of $47 are trading at $.50.
- You write 2 put options contracts with the $47 strike (each contract containing 100 options) and receive $100 for doing so. This is Leg A.
- Puts on Company X stock with a strike of $48 are trading at $.80.
- You buy 1 put options contract with the $48 strike (each contract contains 100 options), costing you $80. This is Leg B.
- Puts on Company X stock with a strike of $46 are trading at $.30
- You buy 1 put options contract with the $46 strike (each contract contains 100 options) costing you a further $30. This Leg C.
- You have spent a total of $110 and received a credit of $10. The total cost of creating the bear butterfly spread is $10.
If Company X stock falls to $47 by expiration
The puts you wrote in Leg A will be at the money and worthless. The ones you bought in Leg C will also be worthless. The ones you bought in Leg B will be worth roughly $1 each: a total of $100. After deducting your initial investment, your overall profit is $90.
If Company X stock falls to $45 by expiration
The put options you wrote in Leg A will be in the money and worth around $2 each, giving you a liability of $400. The ones you bought in Leg B will be in the money and worth around $3 each ($300 in total). The ones you bought in Leg C will be in the money and worth around $1 each ($100 in total). The value of the put options you bought will be approximately equal to the liability of the ones you wrote, meaning your loss would be the initial $10 investment. This would also be true if the stock fell any further than $45.
If Company X stock remains at $50 by expiration
The puts you bought and the ones you wrote will all expire worthless. You'll have lost your initial investment of $10. This would also be true should the stock rise above $50.
Profit, Loss & Break-Even Calculations
- Maximum profit is limited.
- Maximum profit is made when “Price of Underlying Security = Strike Price of Leg A”
- Maximum profit, per option in Leg B, is “(Strike Price of Leg B – Strike Price of Leg A) – (Net Debit /Number of Options in Leg B)”
- Maximum loss is limited to the net cost of creating the spread.
- Maximum loss is made when “Price of Underlying Security > or = Strike Price of Leg B” or “Price of Security < or = Strike Price of Leg C”
- The Upper Break-Even Point is when “Price of Underlying Security = Strike Price of Leg B – ((Price of Options in Leg B + Price Options Leg C) – Price of Options in Leg A)”
- The Lower Break-Even Point is when “Price of Underling Security = Strike Price of Leg C + ((Price of Options in Leg B + Price Options Leg C) – Price of Options in Leg A)”
Summary
If you are confident that you can accurately forecast the price that a security is going to fall to, then the bear butterfly spread is a good choice of strategy for you. The relatively low initial investment required and the limited potential losses are appealing, but accurate forecasts are essential as the spread only makes profits within a small price range.
