Skip Strike Butterfly with Puts
If you’re buying and selling options contracts or considering adopting any sort of options strategy, you need to know about the Skip Strike Butterfly approach. I know it sounds like a weapon your kid might get in Fortnite. However, this complex but ultimately lucrative strategy can drastically change your income potential while giving you yet another powerful tool for your trader’s tool belt.
Let’s get started by discussing precisely what the skip strike butterfly strategy is. Some people call this a broken wing or split strike butterfly, but they all refer to the same basic approach. Essentially, it’s an options strategy consisting of three different put positions.
The goal is to put you in a position to profit from small downward movements in the stock price while simultaneously limiting potential losses from any upward movements. As you probably figured out from the verbiage alone, this is quite similar to the skip strike with calls. However, by focusing on “puts,” we’re specifically trying to profit from downward movements in a stock price.
If you’re a more experienced options trader, you might want to think of this as embedding a short put spread inside a long put butterfly spread, where you’re selling the short put to pay for the butterfly. If that sounds confusing to you, don’t worry. We will provide a lot more information as we dig deeper into the strategy itself.
As I mentioned a moment ago, the Skip Strike Butterfly is a position consisting of three puts. These include a long out of the money put, a short out of the money put, and a long in the money put. For the sake of keeping things brief and covering as much trader terminology as possible, I’ll sometimes refer to these by their abbreviations: OTM, ATM, and ITM.
Now, let’s go over each one in a little more detail.
Your long out of the money put is the first leg of the strategy. Put simply, you’re buying an OTM put option, which gives you the right to sell the underlying stock at a specific strike price. This puts you in the position to profit if the stock price decreases significantly.
Your short at-the-money put is the process of selling an ATM put option, thereby generating
income from the premium received. However, as no trading strategy can be 100% foolproof, this also exposes you to potential losses if the stock price drops significantly.
That’s where your long in the money put comes in. This final part of the strategy involves buying an ITM put option, thus protecting yourself against those same large downward movements.
Now that we know what’s involved, let’s talk about the distance between strikes. In the skip strike butterfly, the distance between the two lowest strike prices – the long OTM put and the short ATM put – is twice as wide as the distance between the two highest strike prices – the short ATM put and the long ITM put. This uneven distribution of strike prices is what’s going to provide you with profit potential while reducing your exposure.
Now, let’s talk briefly about how this fits into the so-called “three-legged options family.” This is the umbrella term used to refer to trading strategies that involve the simultaneous use of three different options contracts. These strategies have names like “Iron Condor,” which can make them sound like a military operation. And I guess if you’re really serious about trading, that analogy is pretty apt.
Again, what we’re doing here is similar to the skip strike with calls, but with a focus on downward movement. This is in contrast to strategies like long spreads with calls and puts, which aim for directional price movements. The way most options traders see it, this offers higher risk, but also higher potential rewards compared to simpler strategies.
In fact, this is a great time to talk about the Pros and Cons of the Skip Strike Butterfly in a little more detail. After all, I never want anyone reading to attempt any new trading strategy without being fully aware of how doing so can affect them. In the end, you have to make the judgment when it comes to risk vs. reward.
So, the primary benefit of the Skip Strike Butterfly approach is that it’s possible to generate significant gains from a relatively small price moment. As smaller movements tend to be much more common than massive runs and drops, this can be an enticing feature for any options trader.
While you can earn quite a bit from having the price stay within the range of the two middle strike prices, you also don’t have to worry as much if the stock does surge upward. With the protective long ITM put, your overall losses are limited – but never zero.
Finally, the Skip Strike Butterfly is generally more profitable than vertical spreads, especially when the stock price in question behaves as expected. Other benefits include the overall cost-efficiency compared to other options strategies and the well-defined risk-reward profile. As smart traders, we always want to have as much control over our risk as possible. The more comprehensive a view we can get, the faster we can react when making those crucial trade decisions.
Taking all of that into account, let’s talk about the disadvantages of the Skip Strike Butterfly strategy for a moment. Now, depending on who you ask, you may get all sorts of different estimates as to just how risky this trading approach is. But it’s important to remember that every trader’s opinion is based on two things…
Their personal experience.
Their personal definition of what constitutes an acceptable gain and an acceptable loss.
This is something to keep in mind whenever you listen to someone give investing advice. If I lost my shirt on a straddle two years ago, it’s unlikely I’d I come on here and talk glowingly about the strategy. But someone who bought their second home from a lucky straddle might tell you it’s the bee’s knees.
Just something to keep in mind.
In all fairness, the Skip Strike Butterfly carries more risk compared to vertical spreads, especially in volatile markets. This strategy can be rather complex, so novice traders with less experience with options pricing, implied volatility, and the mechanics of the strategy itself will sometimes be at higher risk than more experienced traders.
Next – and you should expect this – you will see a higher impact from a large downward price movement. Because the skip strike butterfly is mainly designed to offer protection against large upward movements, traders can suffer substantial losses if the stock price falls more than expected.
So, given those pros and cons, what situations are best for implementing a Skip Strike Butterfly with puts? The way I see it, the ideal situation for maximizing your profit potential while limiting your losses is to find a stock whose price is either holding or declining slowly. I generally look for tickers with a moderately bearish outlook, because I want them to decline, just not dramatically. Other experts suggest looking for stocks that are anticipating limited price movement. This is a good way to establish a predictable range.
On the other hand, there are times when you absolutely do NOT want to use a Skip Strike Butterfly approach. The big one is when there’s an earnings release before the option’s expiration date. We all know that earnings can generate huge price swings, and this is precisely what you’re trying to avoid with this strategy. A more general rule of thumb would be to avoid using this strategy whenever there’s a lot of volatility within a single stock or within the market as a whole. Volatility doesn’t necessarily mean you’re going to lose money, but it does increase your overall risk.
To sum things up, the Skip Strike Butterfly with puts has a lot of potential for new and experienced options traders. Just keep in mind that the goal here is to profit from slight downward movements in the stock price while managing risks associated with upward movements. If conditions are right and volatility is low, this can be a great way to boost your earnings.