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How To Trade A Long Put Butterfly

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I have already discussed how to trade Long Call Butterfly and Short Call Butterfly. This article discusses how to trade a long put butterfly.

Note: Most traders I have talked to like to play butterfly with call options and not with put options. I think it has more to do with human psychology than anything technical. We love to buy call options more than the put options, don’t we? I do not know the reason why, but I think we perceive markets going up more rather than down.

The fact is, it does not matter what option you are choosing to play a butterfly with, the risk reward will remain the same. Whether you trade a long put butterfly, or a long call butterfly – the risk and reward will be same.

When to Trade A Long Put Butterfly?

You should trade a long put butterfly when you have the view that the markets will consolidate for a few days. If Nifty does not move much and remains range-bound, you should be able to profit.

Risk: Is Limited
Reward: Is also Limited

Long Put Butterfly Trade:

1. Sell 2 ATM Put Options
2. Buy 1 Immediate ITM Put Option
3. Buy 1 Immediate OTM Put Option

Let me take a live example of market closing rates on Monday October 20, 2014.

India VIX is at: 14.19 (It is down 13.48% from previous close. But since you will be both a buyer and seller of nearby options – INDIA VIX does not have a big role to play in your trade. So while trading long put butterfly, your view is important – volatility cannot do anything to help or harm you. However if the volatility is high, it will help you to get good credit while selling ATM options, unfortunately you end up paying more for the other options bought. Vice versa when the volatility is low. As you can see volatility does not have a big role to play here. Though high volatility may bring in slightly more profits not significant.

Spot Nifty: 7879.40 (We will treat 7900 as ATM strike) Lets get the last trading prices of current month options expiring in 10 days from today:

1. Sell 2 7900 Put Options: 67.10
2. Buy 1 8000 Put Option (In The Money): 127.80
3. Buy 1 7800 Put Option (Out of The Money): 33.05

Calculations:

Sell 2 7900 Put Options: 67.10 * 50 * 2 = 6710 (Credit)
Buy 1 8000 Put Option: 127.80 * 50 = 6390 (Debit)
Buy 1 7800 Put Option: 33.05 * 50 = 1652.5 (Debit)

Total Investment: 6710 – 6390 – 1652.5 = Rs. (-)1332.50 (Debit)

Margin Blocked (as per NSE guidelines): 25,000 per option sold, 0 for OTM options bought, full money blocked for ITM option bought:

25000 + 25000 + 0 + 6390 = Rs. 56390.00 (Approx)

Now assuming that the trade finished perfect. One the expiry day Nifty is at 7900:

Sell 2 7900 Put Options: Expires worthless. The trader keeps the credit of Rs. 6710.00

Buy 1 8000 Put Option: is now at 100. Loss 100 – 127.80 = -27.8 * 50 = -1390

Buy 1 7800 Put Option: Expires worthless. The trader losses the money paid to buy this option: -1652.50

Total profit: 6710 -1390 -1652.50 = Rs. 3667.50

Return on Investment: (3667.50/56390) * 100 = 6.50% in just 10 days.

Isn’t this a great trade if it works well?

But I do not recommend trading butterfly. Lets see the reasons why?

Supposing the trade did not work well and Nifty is just 100 points up (at 8000) on the expiry day:

Sell 2 7900 Put Options: Expires worthless. The trader keeps the credit of Rs. 6710.00

Buy 1 8000 Put Option: Expires worthless. Loss 100% of the cash to buy it: -6390

Buy 1 7800 Put Option: Expires worthless. The trader losses the money paid to buy this option too: -1652.50

Loss: 6710 – 6390 – 1652.50 = Rs. -1332.50 (The initial cash invested to trade this strategy)

The results will be same if Nifty is anywhere above 8000.

Lets look at the lower end. Nifty is just 100 points below 7900 or 7800 on the expiry day:

Sell 2 7900 Put Options: The 7900 option is at 100. Original value: 67.10. Loss 67.10 – 100 = -32.9 * 50 * 2 = -3290.00

Buy 1 8000 Put Option: Is now at 200. Profit: 200 – 127.80 = 72.2 * 50 = 3610

Buy 1 7800 Put Option: Expires worthless. The trader losses the money paid to buy this option too: -1652.50

Loss: -3290 + 3610 – 1652.50 = Rs. -1332.5 (The initial cash invested to trade this strategy)

It does not matter where is Nifty below 7800, the trader will suffer the same limited loss.

Lets calculate the loss percentage.

NOTE: This is also very important from trading point of view. As a conservative trader, I want to know before trading what is my Max loss in the trade. If I am not comfortable losing that much money I do not trade or reduce the lot size.

(-1332.5 / 56390.00) * 100 = -2.36%.

Yes the risk-reward of -2.36% to 6.50% in just 10 days looks very attractive and traders get attracted to the Long Put Butterfly or the Long Call Butterfly, due to this. But unfortunately most butterfly trades are losers. WHY? Because a 100 point movement can come anytime – even in 1 hour. How can you avoid that?

The trade looks good when initiated, but as time passes and Nifty starts to move in any direction – you will start feeling the pinch. Traders are left hoping and praying Nifty does not move. With this trade what you are essentially hoping is that from the second you put the trade, Nifty should remain in a very tight range. How many times will that be possible? Possibly 1 in 10 times.

Is there any adjustment strategy to the Long Put Butterfly?

No. The only thing you can try doing is to move your trade where Nifty goes, you want your sold strike to remain ATM. Frankly, every time you do this, you will lose money. By the time the expiry day arrives, you may have lost so much money that even if Nifty expires at your new sold strike position – the profits will not be enough to cover the losses done while adjusting. The whole experience will also frustrate you. As you may have done a number of adjustments and even after Nifty finishing where you wanted, the trade was a loser. Your broker was a winner though. πŸ˜‰

The only way out is to trade this when the expiry is very near – like today – expiry is just 10 days away. Or trade even just 5 days away as the risk and reward is limited. However after that your only job is to hope that Nifty finishes where you want it to be on the expiry day – adjustments if any will cost you. Close the trade at 3.15 pm on expiry day. If you made a profit, consider yourself lucky – the trade had nothing to do with your profits. πŸ™‚ Do you really want to trade this now?

This is the major reason why I discourage any trade that requires any kind of prediction. If you want to predict – predict for the worst outcome – you will become a better trader. I encourage you to try non-directional trades where almost no prediction is required.

Today is Diwali 2014. Here is wishing you all a Very Happy Diwali and great trades in the future.


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About the author: I started trading stock markets since 2007. However my first 3 years were losses. Then I dedicated almost 1 year on studying, researching, paper trading options and learned a lot in that time. Since 2011 I am trading Nifty options profitably. Call me if you need any help trading options on 9051143004.

{ 4 comments… add one }
  • Sanjoy

    Nice One Dilip.

  • vaib

    Good one dilip. Will be helpful if u write bit more on delta neutral non directional strategies with minimum adjustments.

    • Thanks Vaib. Yes when we were talking over the phone yesterday and you told me how you try delta neutral adjustments – I started thinking of writing on delta neutral strategies. But delta neutral will need adjustments – otherwise it won’t remain delta neutral πŸ™‚

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