Are you wondering what broken wing butterfly options are and how you can use this strategy to make a profit?
The “butterfly” and the “broken wing butterfly” are defined risk spread strategies, having limited risk and where the maximum potential loss is known before entering the trade.
The butterfly, however, has a low probability of success. Making an adjustment to the structure changes the trade into one that has a high probability of success, called a broken wing butterfly.
A Review Of Spread Options
First, recall that vertical spreads are constructed using options of the same class and the same expiration date, but with different strike prices.
Strike price data are displayed in vertical columns on a computer screen, thus the name vertical spreads.
A vertical spread consists of:
1. Purchasing an option at one strike price (a “long” position).
2. Selling an option at a different strike price (a “short” position).
Both options will be the same type (either calls or puts), have the same expiration date and the same number of contracts.
“Call spreads” are created using call options, and “put spreads” are constructed using put options.
There are four vertical spread trading strategies: the bull call debit spread, bear put debit spread, bear call credit spread and bull put credit spread.
• Bear Call Credit Spread – One option is purchased (the long call) and another is sold (the short call) at a higher strike price. This will generate a net credit (cash into your account) immediately upon execution. The outlook for the stock is neutral to down.
• Bull Call Debit Spread – A short call option is sold and a long call option is purchased that has a higher strike price. The trade results in a net debit to the account. The outlook for this stock is up.
• Bear Put Debit Spread – One long put is purchased while another put that has a lower strike price is sold. The trade results in a net debit to the account. The outlook for the stock is down.
• Bull Put Credit Spread – One short put is sold and another long put is purchased at a lower strike price than the short put’s strike. This will generate a net credit (cash into your account). The outlook for the stock is neutral to up.
Credit spreads give risk protection compared to simply buying or selling calls and puts individually.
They have a higher probability of success, however, the maximum profit potential of a spread is capped, whereas selling a call or put option has the potential for unlimited profit.
The Butterfly Spread
A butterfly spread is constructed by combining a long vertical spread and a short vertical spread.
Both spreads share the same short strike and same expiration date. The width between the two outer “wings” and the center short strikes are the same.
Butterflies (and broken wing butterflies) can be traded using calls or puts. Let’s look at the butterfly setup, which is the starting point for creating a broken wing butterfly trade.
Assume the fictitious corporation Shaky Savings Bank’s current stock price is $10. Your assumption is that over the next two weeks the price will remain about the same (a neutral opinion).
To construct a butterfly spread:
• Buy one $11 strike call
• Sell two $10 strike calls
• Buy one $9 strike call
You believe the stock price will be at $10 at expiration, so you pick the $10 strike for the two short calls.
Notice that this construction is actually a combination of a short call spread and a long call spread, with both of them having the same short strike. You want the short options to expire worthless.
Ideally, if the stock price is at the short strikes ($10) on expiration day, the trade will be worth even more.
Figure #1 shows a profit/loss graph for a butterfly. The maximum profit here would occur if the stock price is exactly at $10 on expiration day.
As you can see from the graph, there is a narrow window of making a profit. The assumption is that the stock price will not move before expiration, thus it’s a neutral position.
Butterflies are typically held short term, from a few days to a week, because it is hard to predict a stock’s price further out in time. Time decay works in favor of the trade.
Butterflies result in a debit to your account, but they are very cheap to buy, as low as 10 or 20 cents.
Thus, they require very little “buying power reduction” from your trading account (collateral held by the brokerage).
Buying power reduction is equal to the debit you paid (plus commission fees).
The butterfly option trading strategy is a way to play a neutral assumption on a stock without taking on a lot of risk.
It looks to take advantage of a sideways movement of a stock, expecting the stock to stay in a very tight range. The butterfly structure results in a debit.
Many traders are attracted to this strategy because they are cheap to buy (and therefore are low risk), and there is a potential for a big profit.
The problem with this strategy is that there is an extremely poor probability for success.
By moving one of the “wings” we can turn the trade into one that has a high probability of profit, as we’ll show next.
The Broken Wing Butterfly Spread
By moving one leg (or “wing”) of a butterfly further away from the center strike (thus the name “broken wing”), a butterfly can be turned into a trade that has a higher probability of profit and results in a credit, rather than a debit upon entry.
You may see the broken wing butterfly strategy referred to as a “skip strike butterfly” because rather than the two outer “wing” strikes being equidistant from the center short strike options, one “leg” is “broken” by moving it one strike further away from the short strike.
Figure #2 shows a common broken wing butterfly structure using put options. The assumption here is that the stock will remain neutral or move slightly bearish over the next week.
This trade is “out-of-the-money” (OTM), being placed below the current stock price.
The wider short put spread part of the trade pays for buying the long put spread, so a credit is received when the trade is placed.
The hope is that on expiration day the stock price will be above the options, expiring worthless and letting you keep the full premium received.
Since all of the options are OTM, any risk to the upside movement of the stock is totally eliminated.
Ideally, the trade can be worth even more if the stock price does drop a little, and lands between the middle short strike and the long higher put strike. This is the “sweet spot,” because the higher long put option now has value.
This potential boost in profit gives the broken wing butterfly an edge over simply trading a call or put spread. This is, however, difficult to achieve.
Therefore, these strategies are not used specifically to hit that area of maximum profit. It’s a nice extra shot of profit when it happens.
Note: When using calls instead of puts, the credit spread side will be to the upside. Figures #3 shows a profit/loss graphs of broken wing butterfly using put options, and Figure #4 uses calls.
Stock Movement Scenarios
In the example shown in Figure #2, if the stock price goes down a little, it’s will be advantageous, as long as the two short puts are not breached.
In fact, ideally you want the stock to drop just until it falls in the sweet zone, where it increases the value of the trade.
Should the stock price move sideways or upward, the odds of the options expiring worthless increase, thus allowing you to keep the full premium received as profit. The time decay characteristic of options works to our benefit.
No one knows for sure how a stock price will move in the future, and should you be wrong about how far the price falls, you will lose money if the short strikes are breached.
Applying TastyTrade® Mechanics
The popular option trading website TastyTrade.com® and it’s team of professional options traders and data analysts prefer using broken wing butterflies to regular butterflies.
In addition, although these trades can be configured to be “at-the-money” (ATM), “in-the-money” (ITM) or “out-of-the-money” (OTM), they use all OTM options.
Their philosophy is to enter trades with a credit rather than a debit, and therefore they use OTM options.
Former CBOE floor trader Tom Sosnoff of TastyTrade® had his research team analyze data comparing butterflies to broken wing butterflies, with the result causing him to vow never to trade a standard butterfly spread again.
Their study showed an 8% percent return on one stock using a butterfly compared to an almost 80% return using a broken wing butterfly.
Can You Trade Broken Wing Butterfly Spreads On Robinhood®?
The Robinhood® platform, which is used by many who are new to trading or who have small account sizes, also supports trading vertical option spreads, iron condors and broken wing butterflies.
While there are no commission fees for placing trades on Robinhood, TastyWorks® typically has faster executions and better fill prices, often negating the fact that a commission is charged on Tasty’s platform.
Also, Tasty’s platform is well designed for easy evaluation of the metrics needed to construct option trades.
Broken Wing Butterfly Options: The Take-Away
A broken wing butterfly is a defined risk spread with a high probability of making a profit.
Instead of having two ways to lose as with a standard butterfly strategy (you lose if the stock moves up or down), the broken wing strategy reduces or eliminates risk to one side (depending on it’s relationship to the current stock price).
The maximum potential loss, however, is greater with a broken wing butterfly than a standard butterfly.
The strategy can be constructed using ATM, ITM or TOM options, but using all OTM options is recommended.
Long lengths of time until expiration increases risk, because time gives a greater chance for the stock price to move beyond your assumption.
Therefore, use shorter time periods than you would typically use when choosing expiration dates.
Use broken wing butterflies in high implied volatility (IV) environments in order to capture a higher premium.
High IV stocks also allow you to go lower with strikes and still receive a good premium, making it cheaper to buy back the spread. Furthermore, if IV contracts (shrinks) it has a positive effect on the trade.
Avoid holding trades during periods when company events can cause large moves in a stock’s price. These include exdividend dates, earnings announcements and new product launches.
Exiting The Trade
With OTM setups, you win if the stock stays above (when using puts) the short strike price.
If a stock begins to move against you, buy it back. You can close for a credit as long as the stock price is between the higher long put and the short put).
You don’t have to hold trades until expiration day. If you reach 50% of maximum profit, exit prior to expiration day to reduce the risk of the trade turning against you.
Maximum profit (using puts) is the initial credit received plus the width of the long put spread.
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