Construction
The short put butterfly is almost identical to the short call butterfly. Their difference is that the former consists of puts and the latter consists of calls. The short put butterfly involves three different strikes and it is constructed by a short ITM put, a short OTM put and two long ATM puts. The two short puts strikes should be equidistant from the middle long puts strike.
It is a credit spread because the money we earn from the short puts is more than the money we have to pay for the long puts.
When to use
When we expect that the price of the underline security will move in either direction at least at or beyond the short puts strikes. Preferably we want the underline security to be at or above the higher ITM strike or at or below the lower OTM strike in order to achieve maximum profit, which is limited to the net premium received. Maximum potential loss occurs when at expiration the price of the stock is exactly at the middle ATM strike.
If the underline price at expiration is above the higher strike all options expire worthless and we have the full net premium received as profit, minus commissions. Below the lower strike the two short puts are exercised against us but the losses are fully counter-weighted by the two long puts at the middle, so we have again the full net premium received as profit.
Loss/Profit at expiration
Maximum loss: (Middle strike price – lower strike) + net premium received – commissions.
Maximum profit: Net premium received – commissions.
Profit/Loss diagram
Below we can see the profit/loss diagram for the short put butterfly strategy. We are short one ITM put with strike $28 and premium $3.50, one OTM put with strike $22 and premium $0.50 and long two ATM puts with strike $25 and premium $1. Notice that it looks the same as the profit/loss diagram of the short call butterfly.
Short put butterfly strategy example
In the daily chart of stock WFC (below) we believe that due to high market volatility, its price will break the support (line 1) or the resistance (line 2) in about a month. The stock is already consolidating for a long period of time and price has visited the support and resistance lines for more than once, which augments the possibility of a breakout or breakdown. When the stock is at point A we can apply the short put butterfly strategy by writing one ITM put with strike $28 and premium $3.50 and one OTM put with strike $22 and premium $0.70 and purchase two ATM puts with strike $25 and premium $1. All the options are expiring in about one month. The net premium received for the opening of the position is $220 {[($3.50+$0.70)-(2x$1)]x100}.
If the stock price at expiration is exactly $25 (ATM strike) then we have the maximum possible loss (without estimating commissions), which is the middle strike minus the lower strike, multiplied by 100 minus the net premium received, meaning $80 {[($25-$22)x100]-$220}.
If the stock at expiration is at or below the lower strike i.e. at $20, then we are losing $8/share because the short ITM put is exercised against us. We are also losing $2/share from the short put with the lower strike ($22) which is also exercised against us but we are winning $10/share from the two long puts with strike $25 [($25-$20=)x2=$10/share]. So, the total loss is equal to the total profit and what remains in the end is the net premium received.
If the stock at expiration is above the higher strike then all options are worthless and our profit again is equal to the net premium received.