Broken wing butterfly option trade

Broken Wing Butterfly Spread.

Broken Wing Butterfly Spread - Introduction.

The Broken Wing Butterfly Spread, also known as a Skip Strike Butterfly Spread, is neutral options strategy and is a variant of the Butterfly Spread options trading strategy. The Broken Wing Butterfly Spread is simply a butterfly spread with risk inclined to one side. This means that rather than an equal risk when the stock breaks out to topside or downside, the Broken Wing Butterfly Spread transfers all the risk in one direction onto the other in order to create a options trading risk profile with maximum loss when the stock goes either upwards or downwards and totally safe when the stock goes in the protected direction.

Broken Wing Butterfly Spread - Risk Adjusted Butterfly Spread.

The main purpose of a Broken Wing Butterfly Spread options trading strategy is simply to adjust the risk profile of a regular butterfly spread. A regular butterfly spread makes a loss when the stock breaks out to either direction. A Broken Wing Butterfly Spread enables you to totally transfer the risk of one direction onto the other. This is useful when you wish to speculate on a stock being stagnant but that you are confident that if the stock should break out, it will do so only in a certain direction.

Please click on the respective risk graph to learn about each variant of the Broken Wing Butterfly Spread.

Broken Wing Butterfly Spreads.

We’ve gone over long butterflies and short butterflies, but that’s not where our butterfly trading ends. We can also trade broken wing butterflies (BWB), also referred to as skip strike butterflies, to increase our probability of profit (POP) and collect a net credit for a trading strategy similar to a long butterfly, where we would normally pay a net debit.

What is a Broken Wing Butterfly?

A broken wing butterfly spread is a long butterfly spread where the farthest out of the money (OTM) strike price long option is bought farther away from the middle short strike price than the other option you are long.

If you think of a butterfly spread as having two middle options, the “guts”, with outside options on either side, the “wings,” a broken wing butterfly is where one wing is bought farther out from the middle “guts” than the other wing. You can imagine it as a broken, unbalanced, or lopsided wing.

A normal long butterfly is balanced with strike prices like $98.00/$100.00/$102.00 (both long wing options are equidistant from the middle short options). A broken wing butterfly would have strike prices like $98.00/$100.00/$105.00 (the long $105.00 option is $5.00 away from the middle options, while the $98.00 long option is only $2.00 away).

Purchasing the long option farther out of the money lowers the total cost of the spread. This is because the further OTM we go, the lower the premium will be for an option. Depending on the option premiums, we can choose an option far enough out of the money to turn what normally is a net debit trade into a net credit or even ($0.00) trade. Looking for underlyings with high implied volatility rank (IVR) makes it easier to place BWB spreads, because we receive more premium for the short options we sell.

When the trade becomes a net credit trade, we eliminate our risk in one direction and increase our risk in the other.

Having a net credit means our trade will be profitable as long as the middle short options expire out the money. If the spread expires out of the money worthless, we keep the initial credit received for putting on the trade. We can see this on the dough curve page as the green profit area extends downwards for call BWB's and upwards for put BWB's. The initial credit also acts as an extra buffer if the middle options go in the money. To make the trade for a credit, though, we increase our risk on the out of the money side of the trade.

Because the long option is farther away from the short options, the spread has additional risk if the short options go in the money. There is more room for the short options to be in the money, before the long option also goes in the money to offset losses. Like in our earlier $98.00/$100.00/$105.00 example, the middle options can each be $5.00 in the money compared with only $2.00 in a normal long butterfly spread.

Increasing Our Probability of Profit.

When converting a long butterfly spread to a broken wing butterfly spread you will notice that the probability of profit increases dramatically. Placing the trade for a net credit makes the area where the spread is out of the money a profit area. Instead of needing the underlying inside a narrow range at expiration, the underlying can now be from $0.00 to the [short strike price + credit received + width of long spread] for call BWB’s and anywhere above the [short strike price - credit received - width of long spread] for put BWB’s.

Because we take on more risk on the out of the money side of the trade, we are able to increase the overall probability of profit for the spread.

Market Assumption: Put vs. Call Broken Wing Butterflies.

Normally when trading butterfly spreads we trade out of the money options to lower the chance that part of the spread is exercised early, and to lower our fees when closing out of the position. If the options are OTM at expiration, they expire worthless without us needing to manage the position.

When trading broken wing butterflies we also want to trade out of the money strike prices. When deciding between trading put or call BWB spreads, you should ask yourself what your market assumption is for the underlying.

For both call and put butterfly spreads, your max profit occurs when the underlying expires at the middle short strike prices.

For call BWB spreads, you profit if the underlying expires below the short strike price plus the credit received for selling the spread plus the width of the long spread (pictured above).

profit = stock price < short strike price + credit received + width of long spread.

For put BWB spreads, you profit if the underlying expires above the short strike price minus the credit received for selling the spread minus the width of the long spread (pictured below).

profit = stock price > short strike price – credit received - width of long spread.

It might seem a bit complicated, but placing the trade on dough’s curve page will make the profit and loss areas more clear. You can also use the “Review & Send” screen to examine your max profit, max loss, and breakeven areas.

Call BWBs have a bullish market assumption, but you also profit if the underlying is below the short options at expiration as long as the trade is placed for a net credit. Put BWBs have a bearish market assumption, but you also profit if the underlying is above the short options at expiration as long as the trade is placed for a net credit.

Setting up Broken Wing butterflies in dough.

To trade a broken wing butterfly in dough, you enter the trade as if you are trading a long butterfly spread. Once the spread is on curve or table page, you adjust the strike price of the furthest out of the money option until you receive the net credit you want.

Remember we look to collect a net credit or make the trade for even ($0.00) when buying a broken wing butterfly. Making the trade for a credit allows us to be profitable if the spread expires OTM.

Broken Wing Butterfly Recap.

Broken wing butterfly spreads are similar to long butterfly spreads, but with the furthest OTM wing adjusted even further OTM. We trade broken wing butterflies for even ($0.00) or a net credit. You can trade broken wing butterflies with a bullish or bearish market assumption. Max profit occurs when the underlying expires at the short strike price of the options. Max loss occurs when the furthest out of the money option expires at or in the money. High IVR underlyings allow us to place BWB spreads more easily, because we receive more credit for the middle short options. Trading broken wing butterfly spreads allows us to increase our probability of profit compared to long butterfly spreads.

Have questions about broken wing butterflies? us at supportdough.

How do we calculate an option’s price?

A dynamic short strangle allows to us move options further out of the money and stay delta neutral.

What are the tested and untested sides of a short strangle?

The Broken-Wing Butterfly Trading Strategy.

1,200 Reasons To Be Confused.

There are times when the market is in such a strong trend that even Stevie Wonder could see which direction to trade. Currently, however, the markets area is acting like a conundrum wrapped in a riddle. There are just as many reasons to be bullish as there are to be bearish.

And even the most sophomoric of market technicians is aware of the “magic” Standard and Poor’s 500 major technical number resting at 1,200. The problem is that, since this time last month, the market has crossed over and under SPX 1,200 a dozen times, confusing both bulls and bears alike.

QUESTION: So what do you trade when you are confused about what the future holds?

ANSWER: The Broken-Wing Butterfly (a. k.a. BWB) is an ideal strategy for such situations.

The best way to learn the BWB strategy is to begin with the traditional butterfly spread and go from there.

Most options traders are intimately familiar with the butterfly spread as a low risk strategy that has a high reward potential – if they choose the correct strikes. The construction of the butterfly spread is simple enough. The spread is defined as the simultaneous purchase of one vertical spread (call or put) and the sale of another further out-of-the-money (OTM) vertical spread where both spreads share a common center strike price.

An example would be the purchase of a bearish 1210 – 1200 (near-the-money) put spread. To reduce the initial investment of this $10 wide spread, a trader could sell the 1200 – 1190 (further OTM) spread. Since the 1200 strike option is used twice, you will notice that the resulting butterfly spread has a contract size of one contract by two contracts by one contract.

Using real numbers often illustrates the concept best.

On Friday, September 16, the market is above the 1,200 SPX line, and we will assume that the markets are going to be heading back to that “magic” 1,200 number. We would like to invest in a butterfly where the maximum profit is realized when the S&P 500 gets down to $1,200. Furthermore, because the markets have been so volatile of late, we will stick with the ‘weekly’ options that expire the following Friday (September 23), though we could have chosen any expiration cycle we wanted.

Using the current option prices (Friday’s closing marks) at the close of trading, we quickly put on the 1210-1200-1190 butterfly spread. Recall that the butterfly spread can be thought of as the purchase of one spread and the sale of a further out-of-the-money spread.

Here we see that the traditional butterfly spread can be purchased for a $0.60 debit. Because the SPX has a 100 multiplier, each spread will cost $60 ($0.60 per share X 100 multiplier = $60). By most traders’ definition of “risk vs. reward,” this is a decent trade. Since the most that can be made on a butterfly is the distance between the strike prices ($10 in this example), we are risking $60 to make up to $1,000.

The below risk graph shows a very optimistic picture which could have people running out to open brokerage accounts tomorrow. Hold off for one moment though.

There are two inherent problems with the traditional butterfly:

1. The stock has to close within the range of profitability on expiration.

2. The market could go up instead of down (as we are postured).

How do we fix this?

There is a possible solution to the inherent problem of the butterfly spread – the BWB.

By moving the tail strike (1190 in this example) down one more strike we will be paying less for this spread, thus eradicating the worries that the market could possibly go higher when we are anticipating it going down. We know that the traditional butterfly spread is comprised of a long and short vertical spread of equal sizes. In the above example, we bought a $10 wide spread (1210 – 1200) and sold a $10 spread (1200 – 1190).

But what if we bought a $10 spread and sold a wider spread? Let’s use $15 for our example. Logic would tell us that selling a $15 spread will bring in more money than selling a $10 spread, and it will. Suppose, for example, that we bought the same 1210 – 1200 put spread since we believe that the underlying is going back to $1,200. Then, instead of selling the 1200-1190 put spread ($10 wide), we sell the 1200 – 1185 ($15 wide) put spread. Using the same option chain as above you will notice that we will be receiving a CREDIT of $0.50 instead of paying a $0.60 debit.

The movement of the ‘tail’ strike (1190) down to 1185 will have an adverse effect on the risk graph. As a matter of fact, comparing the traditional butterfly with the BWB will lead to an impulsive decision to go with the former rather than the later at first glance.

1210 – 1200 – 1185 Broken-Wing Butterfly.

The profit and loss graph above shows that the downside break-even point (the place where the BWB will stop making money and will start to lose money) is at $1,189.50. Below the break-even point, the position starts to lose money. Many traders will be concerned about the possibility of losing up to $4.50, and thus prefer the traditional butterfly.

When deciding between the traditional butterfly and the BWB, you must consider how much safer the BWB is over the long run. The BWB is safer for three reasons:

Instead of paying a $0.60 debit, a loss that will occur often with the traditional butterfly, we will be receiving a credit of $0.50. This swing of $1.10 goes a long way to offsetting the $4.50 risk over many expiration cycles.

The break-even point of roughly $1,190 in the SPX cash is currently $26 out-of-the-money.

Most importantly, the long $10 spread that is close to ATM brilliantly protects the short $15 spread that is OTM. Recall that the “scary” BWB chart shows how the spread looks at the moment of expiration. Prior to expiration, the position is very well protected, and an example will prove just that.

Suppose that the market in the S&P fell $30 the moment after you placed the BWB trade. This would bring the SPX down to $1,186.01 ($1,216.01 – $30 = $1,186.01). You are now concerned about this area because it is getting close to falling below your break-even. There is a simple fix for determining what your spread would look like should the market actually fall that far and fast. It may sound confusing at first, but it is simple. Stick with us.

All we have to do is look at the equivalent spread that is $30 higher in strike prices to determine what the spread would look like if the market fell $25. Recall that, as the market falls, the first long 1210 strike put will go ITM and start picking up value. When the SPX cash is at $1,216.01, the 1210 put is $6.01 out-of-the-money. Should the market fall by $30, that put will go from being $6.01 OTM to being $23.99 in-the-money (1210 strike $1,186.01 SPX cash price = $23.99 ITM).

Thus, the 1210 put we are looking at now (which is $6.01 OTM) will be seem like the 1240 strike put (1240 strike – $23.99 = $1,216.01). If we do the same thing for each strike of the BWB, we can determine what the spread will look like should the market fall to the point on our graph where we begin to hit our maximum loss of $4.50, our scary place.

Current Prices of Options Deep ITM.

The math should calm your nerves if you were concerned about the potential $4.50 loss (at expiration). The long $10 spread that is ATM is a very good hedge against the risk of the short $15 spread that is further OTM. The next graph illustrates what the position looks like PRIOR to expiration. The curve represents what the spread will look like the moment the trade is put on.

Since we introduced the broken-wing butterfly to the world, the spread has caught on with a ferocious fervor. Now, you can see why. Novice and intermediate traders who have been taught that vertical spreads are the way to make money in the markets (and who usually become disenchanted with them) are embracing this strategy en masse. Since this can be done with calls to the upside and puts on the downside (either separately or combined to form a BWB strangle), you can see why this strategy has been termed “One Strategy For All Markets.”

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Broken Wing Butterfly.

Broken Wing Butterfly.

The Broken Wing Butterfly Options Strategy.

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The Broken Wing Butterfly Strategy Course is presented by Greg Loehr, a former CBOE market maker and proprietary trader who serves as an options mentor for numerous trading students throughout the world. This trade is a key part of many veteran trader’s arsenal of theta positive options strategies. Once mastered, it can become a core monthly trade for the intermediate or advanced options trader.

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