Lesson Overview

Butterfly Adjustments

Trading butterflies (and especially broken wing butterflies) give us a lot of flexibility in how we can exit to maximize our potential win rate. Because we trade BWB's much more often than a standard butterfly we will focus this video on adjustments for these strategies. With a broken wing butterfly we are able to buy back the embedded put/call spread should the position move favorably in one direction and leave a remaining risk-free butterfly for a potential one time big profit. While this is a more advanced type of adjustment it's very easy to follow and I will explain it step-by-step in this tutorial.

Show Video Transcript +

In today's video tutorial, we want to talk about how you can adjust a butterfly spread. So trading butterflies and especially broken wing butterflies give us a lot of flexibility in how we can exit to maximize our potential win rate on this strategy.

Now because we traditionally trade a lot of broken wing butterflies here, much more often than the standard butterfly or kind of even or balanced butterfly, we'll focus this video on adjustments for these types of strategies and the type of strategy that you see here with the payoff diagram.

So how do I set this thing up? As a quick refresher, to create a put broken wing butterfly which would be a direction-ally neutral to bullish trade, you're first going to buy one in the money put option typically one strike higher than where the stock is trading right now.

Then you'll sell two slightly out of the money put options, and again, we just say slightly out of the money because we want to maximize our extrinsic value. So we want to sell that strike just below where the stock is trading currently.

From there, we're going to skip over one strike and go out to the next strike and buy one out of the money put option. And again this creates that broken wing aspect to this butterfly spread.

So when we skip over this out of the money put strike, You are leaving the room because you have that skipped strike out there that you missed or went over. You're leaving room to buy back an embedded spread for less than the credit received, to create a risk-free butterfly spread at expiration.

Again, I'll say it again; you're leaving room to buy back that embedded spread for less than your overall credit received, to create a risk-free butterfly at expiration. So basically what happens is that when you make this adjustment, you don't do anything with the first two strikes that you dealt with so it kind of crosses out here.

What you're going to do is you're going to buy one out of the money put, and that's the skipped strike. So you're going to go out and buy that skipped strike, and then you're going to sell one out of the money put at the original strike price that you bought, which is that lower kind of left side of the payoff diagram.

Now this is going to close out that strike and move that side of the butterfly up to the point that you have an even or balanced butterfly.

So let's go ahead and do one on our broker platform here in Think Or Swim. And so what we have here is this is a look at the queues. They currently close today about 104.26.

And you can see we're dealing in March here and so what we did is created a sample broken wing butterfly down here below, and we've got another video tutorial inside the membership area that goes through all of these different strategies here.

But again what we decided to do, is to buy the 105, which is the put that's just above where the stock is trading right now at 104.26. We sold twice as many of the 104s, and then what we did is we skipped over the 103 strike, so that's going to be important as we make this adjustment to this butterfly.

So we skipped over that 103 strike and bought the 102 strike. Okay, now that leaves room in here for the 103, 102 embedded spread. And again you can see we have the 105, the 104, skip over the 103 and have the 102.

Now on this trade, this broken wing butterfly, when we initiate this trade, the pricing gives us a $25 credit. So that's ideally what we want to see. We want to see some sort of credit on the trade. Now here's the profit loss diagram.

You can see this is that broken wing aspect over here. All the way out at 102, and then it leaves us with the profit of $25.00 if the stock moves anywhere above 105 at expiration.

So these are why these are such good direction-ally bullish strategies. But let's say that the stock starts to rally higher, so it moves up maybe from 104 up to about 106. So it starts trading way over here.

Well at this point we can buy back this embedded spread between 102 and 103. So basically what we're going to do is we're going to slide this bottom leg or this bottom side up closer to the market. And the goal is that we make this adjustment spending less than the credit that we have on this trade.

So if we can make this adjustment by spending less than this $25 credit, basically taking the $25 in our hand and spending less money to adjust the position, we'll be left with a risk-free butterfly at expiration with no potential for losing money.

So what we'll end up doing is creating a strategy that looks like this. We'll have this side here, but then it will go to the 103, and then from there it will flatten out into the left side of you're payoff diagram. So that's exactly what we're doing. We're rolling up that side of the trade.

Now this is where it looks like logistically, so again you might have to go through this video a couple of times, but basically what we would do here is we would go ahead and buy back this embedded spread. So we would buy the 103 option, and we would sell the 102 option.

Now in this case, because the market hasn't moved, the pricing is about $32 as far as a debit, but it might be around $20 as the market goes higher or if the market moves up to about 106.

So remember what we're doing here, we're buying the 103, we're selling that 102, and we already owned a 102, so that closes that 102 sides of the trade.

Now when we go here to our risk profile, you can see that we have an even or balanced butterfly right over 104. Because now we're long the 103 puts, we still have the 104s and the 105s from the original trade so again we have this balanced and even strategy over the market.

Now at this point you'll also notice down the bottom left-hand corner of the screen here, at no point does this profit loss diagram go below zero, and that's because we took in a credit of $25 on the trade, we spent $20 to hedge the trade, now we're left with basically a $5 profit no matter where the stock goes.

Now this isn't obviously a huge profit, but what it does is it locks in the potential gain here. We're going to ever lose money on this trade, and it is a lottery ticket in case the market comes back inside of that possible range.

And again if it originally rallied it does have the opportunity to come back inside that range, and we take a trade that we have no risk on, and we can potentially make anywhere between $90 and $100 per contract.

So, a very cool adjustment. We've made these a lot of times with these broken wing butterflies. It's a very flexible way to adjust these positions. So again just to kind of wrap up with some key points.

These work best, and the only possibility when they work is when the stock rallies significantly higher and you want to lock in both a small gain and the possibility of a big profit should the stock fall into your short strike region, like we just went through.

So this, of course, would work in the complete opposite for a call broke wing butterfly. You would buy back the embedded call spread. It works the same way just on the complete opposite.

As always I hope you enjoy these video tutorials. If you have any comments or questions please ask them right below, and until next time, happy trading.

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