In what ways is buying an out-of-the-money put butterfly superior to the outright purchase of a simple out-of-the-money put? The trader’s initial cash outlay is much lower and has less money at risk.
Let’s take corn futures as an example. Trader Jo is anticipating a strong yield in corn despite a possible late start to the growing season due to a very rainy April. The concern is that excessive rains will prevent the corn from being planted on time, thereby bringing early frost problems into play at harvest time. Trader Jo believes that those concerns are not as great as they were a week ago. Consequently, she believes that there will be a record yield at harvest time.
Trader Jo is looking for an options strategy that will benefit from a downward movement in the price of corn. The September corn futures contract is currently trading at $3.95 1/4. That is a notional value of $19,762.50 ($3.95 1/4 per bushel x 5,000 bushels). She could profit by selling a future, selling a call on a future or by purchasing a put on the future. The March 430 Calls are selling for 27.625¢ per bushel ($1,381.25). To harvest that premium, however, Trader Jo subjects herself to unlimited upside risk. The same goes for selling the futures contract.
The Sep 370 Put is trading at 27.875¢ ($1,387.50). To defray the cost of the put purchase, a put one strike lower could be sold. Trader Jo can sell the Sep 360 Put for 23.75¢ ($1,187.50). The net outlay would be 4.125¢ ($212.50). If only the Sep 370 Put was purchased the maximum possible profit on the trade would be $17,112.50. The price of corn would have to go to zero of course. If that happened we all would have bigger problems.
Selling the Sep 360 Put does limit Trader Jo’s profitability. By how much? Because she is selling somebody the right to sell a Sep corn future at $3.60 per bushel, any price movement below the $ 3.60 strike price would no longer be profitable. Trader Jo has established a 10¢ bear vertical put spread. Anywhere at or below $3.60 this spread will be worth its maximum value of 10¢. Anywhere at or above $3.70 this spread will be worthless. Since the trader has paid 4.125¢ ($212.50) for a spread that can only go as high as 10¢ his maximum profitability is 5.875¢ or $287.50.
Is there a way that Trader Jo could reduce her initial cash outlay without increasing her risk? One way would be to sell the next level vertical put spread. In this case it would be the Sep 360-350 corn futures options spread. The Sep 360 Put could again be sold for 23.75¢ and the Sep 350 Put could be purchased for 20¢, 3.75¢ ($187.50) would be collected for this spread. The combination of these two vertical spreads would result in a net outlay of $37.50. The Sep 350-360 achieves its maximum profitability anywhere at or below the $3.50 strike price. It is worthless anywhere at or above the $3.60 strike price. The sweet spot for this butterfly is obviously at $3.60.
Trader Jo now has three choices in how to benefit from this bear move. The straight vertical is about 15% of the cost of the outright put purchase. The butterfly is about 18% of the cost of the vertical. This would allow Trader Jo to take a larger position as well as suffer fewer losses should the price of corn move up instead of down.
Dan Keegan is an options instructor and head options mentor at TheChicagoSchoolofTrading.com