Explanation

Long Put Butterfly is a neutral - three-part option strategy where a trader assumes a bearish market scenario with low volatility.This option strategy involves selling and buying put option, to be precise buying one higher out-of-the-money (ITM) strike put, selling two middle at-the-money (ATM) strike puts, and buying one lower in-the-money (OTM) strike put. All put options should have the same expiry date, and the distance between the higher and lower strikes must be equal from the middle strike. The Long put butterfly option strategy is implemented for a net debit and both profit and loss are limited.

Risk:

The max downside of implementing a strategy is the cost of implementing it.

If the underlying price at expiry is higher than the ITM strike, all putswill expire worthless and the cost of implementing the strategy is forfeited.

If the underlying price fall below the OTM strike price, all putsat that time will become ITM and the position has a net value of zero.

Reward:
Maximum profit is realized when the underlying security price at the time of expiration close to the strike price of the middle short put. If the underlying price at expiry ends as per expectation of the trader, the middle-put option will expire worthless, and traders will gain from the higher put. If the market makes a volatile move in either way, the optionswill start to make loss. Maximum loss is capped and will be limited to premium paid.

Construction

Sell 2 ATM Put Options

Buy 1 ITM Put Option

Buy 1OTM Put Option

PayoffChart

Example

Trader’s view on the market volatility stands to be bearish and he thought of implementing a long-put butterfly strategy. The market is currently trading at 17750 levels. He bought 1 OTM 17700 Put option by paying the premium of Rs. 23, bought another higher ITM put option with paying premium of Rs 57 and finally sold 2 ATM put option and received the premium of Rs. 37 each. His total investment while implementing this strategy would be Rs.300 (23+57-(37*2)) *50.

Scenario 1:

Suppose if at expiry market didn’t trade as per the expectation of the trader and fall to 17600 level. The trader will make a loss as shown in below payoff table.

Scenario 2: if the traders assumption come true and market closes close at the 2 short put option. The OTM put option will expire worthless but the trader will profit from the ITM put option and will keep the premium received.

Scenario 3:

if at expiry market rises and close at the higher strike put. All the option will expire worthless and trader will lose the net premium paid.