In the above example:
- Buy 1 Put strike 95
- Sell 2 Puts strike 105
- Buy 1 Put strike 110
The position may be established for a net debit or a net credit, depending on the bid-ask quotations, and both the potential profit and maximum risk are limited.
Strike prices are equidistant, and all options have the same expiration month.
Risk is limited to the net debit paid: after the trade is paid for, no additional margin is required.
A long skip-strike butterfly spread with puts realizes its maximum profit if the stock price is at the strike price of the short puts at expiration.
Bullish, bearish or neutral strategy
The forecast, therefore, can either be “neutral,” “modestly bullish” or “modestly bearish” depending on where the stock price is compared to the strike price of the short puts when the position is established.
If the stock price is at or near the strike price of the short puts when the position is established, then the forecast must be for unchanged, or neutral, price action.
If the stock price is below the strike price of the short puts when the position is established, then the forecast must be for the stock price to rise to that strike price at expiration (modestly bullish).
If the stock price is above the strike price of the short puts when the position is established, then the forecast must be for the stock price to fall to that strike price at expiration (modestly bearish).
Usually though, a good strategy is to establish the position with the price between 105 and 110, with a slightly bearish expecations; in such a way, before going into the loss position the stock has to make a significant drop in price.
Some investors may wish to run this strategy using index options rather than options on individual stocks. Indexes are less volatile as individual stocks.
Impact of volatility
Long skip-strike butterfly spreads with puts have a negative vega as long as the price of the stock is around the strike of the short puts (105): the net price of a skip-strike butterfly spread falls when implied volatility rises and rises when implied volatility falls.
That’s why some traders open long skip-strike butterfly spreads when they forecast that implied volatility will fall. Long skip-strike butterfly spreads, therefore, should be purchased when volatility is “high” and forecast to decline.
After the position is open, you want the stock price to remain stable around 105 and the volatility to decrease, which will cause these short options to decrease in value, thereby increasing the overall value of the position.
Since implied volatility tends to fall sharply after earnings reports, some traders will open a long skip-strike butterfly spread immediately before the report and hope for little stock price movement and a sharp drop in implied volatility after the report.
If implied volatility is constant, long skip-strike butterfly spreads do not rise noticeably in value and do not show much of a profit until it is close to expiration and the stock price is close to the strike price of the short puts.
On the other side, if the prive moves away from the strike of the short puts and reaches one of the two strikes of the long puts, the whole position becomes positive vega: a raise in volatility inceases the net price of the long skip-strike butterfly spread, and viceversa.
Impact of time
Long option positions have negative theta: they lose value from time erosion, all other factors remaining constant; and short options have positive theta, which means they make money from time erosion.
A long skip-strike butterfly spread with puts has a net positive theta as long as the stock price is near the strike price of the short puts (105 in our example). If the stock price moves away from this strike price, however, the theta becomes negative as expiration approaches.
While the margin requirement for most spread strategies is equal to the maximum risk of the strategy, this is not the case for skip-strike butterfly spreads.
In this strategy, the bear put spread and the bull put spread are margined separately.
Consequently, the total margin requirement for a skip-strike butterfly can be greater than the maximum risk of the strategy.
In the example above, the 110-105 bear put spread is purchased for a net cost of 3.60 (8.25 – 4.65) not including commissions, which is the maximum risk of this spread.
The 95-105 bull put spread is sold for a net credit of 3.95 (4.65 – 0.70), and its maximum risk if 6.05 (10.00 – 3.95).
First, for purposes of margin, the bear put spread must be paid for. In the example above, $360 of cash is set aside from account equity.
Second, the margin requirement for the bull put spread is the maximum risk of the spread, or $605 in this example.
Therefore, the total margin requirement for the skip-strike butterfly spread in the example above is $965 ($360 + $605), not including commissions.
Note that the cash received for the bull put spread is held in reserve as part of its margin requirement; it is not applied to the cash paid for the bear put spread.