How to Set Up a Broken-Wing Butterfly Option Strategy

A lot of traders have asked me about broken-wing butterfly option strategy in the past, so I thought I’d create a blog dedicated to exactly how you would set up this kind of spread and why you would want to.

What is a broken-wing butterfly?

A broken-wing butterfly (BWB) is very similar to a traditional iron butterfly, with one key difference: the out-of-the-money long options are not equal distance from the short strikes. When purchasing the long options, at least one long strike price is closer to the short strike, thus creating a “broken-wing.”

Oddly enough, the broken-wing butterfly isn’t a new strategy and has been around for years. Recently though, the butterfly has been gaining attraction for the simple fact that you can enter the trade to minimize risk in one direction, potentially setting up a directional risk-free trade with guaranteed profit – if you follow the plan below.

Iron butterfly options strategy

It’s only right to start at the beginning by looking at a more typical iron butterfly to make sure you understand that first. An iron butterfly is a multi-leg, risk-defined, neutral strategy with limited profit potential. Iron butterflies are typically market neutral with no directional bias, and look to capitalize on a decreasing volatility, time decay, and minimal movement from the underlying stock to be profitable.

For example, if a stock is trading at ~$235, a call option and put option could be sold at the $235 strike price, with a long call purchased at the $245 strike price and a long put purchased at the $225 strike price. This would create a $10 wide iron butterfly. If the credit received to enter the trade is $6.70, the max profit would be $670 and the max loss would be -$330.

• Buy-to-open: $225 put
• Sell-to-open: $235 put
• Sell-to-open: $235 call
• Buy-to-open: $245 call

This creates that famous peaked profit/loss diagram which looks like a butterfly, hence the name! The goal with these is to capture a return if the underlying stock not move much between now and expiration. Of course, this is rarely the case, but hopefully you can exit the trade for a profit before expiration.

Evolution of The Broken-Wing Butterfly (BWB)

I guess you could say that the broken-wing butterfly was the next evolutionary step in the options trading strategy. Traders quickly discovered that it can be possible to open a BWB and essentially eliminate risk to one side of the position. Let's explore how...

Let's use the example above, but with a slight tweak to the long call strike.

Notice the long call strike is now $240. Although the max profit is slightly less, the new trade structure has no risk to the upside. In fact, the worst case scenario if the stock price increases is a $55 profit!

The key is to bring in more credit than the width of the more narrow spread. In this example, the credit to to open is $5.55 and the call spread is only $5, which creates the risk-free trade to the upside. Of course, there is still risk if the stock drops. Anything below $229.45 loses money, and below $225 the position will have a max loss of -$445.

This can easily be applied to the put side as well if you want to cap downside risk. Whichever side you choose to set up the broken wing depends on your outlook for the stock.

How Do I Set Up A Broken Wing Butterfly?

Just like the original butterfly, with a BWB you are going to sell two at-the-money options (one put and one call) and buy out-of-the-money long options to define the position's risk. However, our goal is to minimize risk to one side. For example, if you're worried a stock may shoot up significantly, but are less concerned about a meaningful drop in price, you may choose to buy a call option that is closer to the short call.

By capturing a premium higher than one of the spread's width, you can essentially enter the trade for a credit that is greater than the max risk to one side. How’s that for a more creative strategy?

So How Do I Begin?

Like anything else you learn about in options trading, you should always start by paper trading the strategy first for a couple of months before you put real money to work. It's super easy to set up BWB manually in for any ticker in Option Alpha.