How to Set Up a Broken-Wing Butterfly Option Strategy
A lot of members have asked me about broken-wing butterfly option strategies 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.
The out-of-the-money long options are not equal distance from the short strikes. When purchasing the long options, at least one strike price is skipped, 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 them without any investment or even at a credit – if you follow the plan below.
So, if you’re dying to know more about this lopsided creature, read on my friend!
The Original Butterfly Spread
It’s only right to start at the beginning by looking at a more typical butterfly spread to make sure you understand that first. The call butterfly spread is created by selling two at-the-money calls and then, at the same time, buying one out-of-the-money call and one in-the-money 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 huge return should the underlying stock not move much between now and expiration. Of course, this is rarely the case but if you can pinpoint the closing price you will end up with a strong profit.
Evolution of The Broken-Wing Butterfly (BWB)
I guess you could say that the broken-wing butterfly (BWB) was the next evolutionary step in the trading environment because a typical butterfly comes with two distinct drawbacks – you have to enter it with a debit from your account, and it requires little movement in the underlying to make money.
Butterflies were not very trader friendly in nature, so traders started to play around with strikes and numbers of contracts, and the BWB was born.
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 calls and buy one in-the-money call. However, this time you are going to SKIP over the next out-of-the-money call strike and move up one extra level.
This creates spacing between the at-the-money call and the out-the-money call allowing you can capture more premium.
- Buy one In-The-Money Call
- Sell two At-The-Money Calls
- Skip a Strike
- Buy one Out-Of-The-Money Call
By capturing a higher premium from the sale of the calls, you can essentially enter the trade for either a slight debt or, better yet, a credit to your account. How’s that for a more creative strategy? With the additional upside potential, you have to remember that you are also acquiring extra risk.
What’s The Goal With A Broken Wing Butterfly?
If you establish the trade for either a credit or slight debit the goal, of course, would be for the stock to close around the ATM strike or below, by the time of expiration.
The ability for the stock to fall at the same time and still make money is the single unique feature offered by the broken wing butterfly. A traditional butterfly would show a significant loss should the stock fall, before expiration. Now the stock can remain neutral and fall, and you still make money. Again the trade-off being the bigger loss on the upper end should the stock rally violently.
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. Test this out on your preferred broker’s platform and have fun with it.
My goal as always is to introduce and help explain these strategies so that it’s easier for you to put them to work and finally start making some money trading.
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