Options trading offers a wide range of strategies to capitalize on market movements and manage risk. It’s been said that they are called “options” for a reason which is simply that you have a lot of options! One such strategy is the broken wing butterfly. In this article, we will explore what a broken wing butterfly is, how it works, and why traders may consider using it.
The Broken Wing Butterfly Explained
A broken wing butterfly is an advanced options strategy that combines elements of a traditional butterfly spread with an adjustment to one of the wings. It involves buying and selling different options contracts to create a position with defined risk and potential profit. There are many reasons why a trader would want to construct a broken wing butterfly rather than a traditional butterfly which we’ll get into shortly.
How to set up a Broken Wing Butterfly
For simplicity, we will assume only calls in our example. The same structure can be applied to puts by simply assuming that the different wings are moving down in price rather than up. Let’s use TSLA stock as an example and see how we could set up a broken wing butterfly.
You’ll see in the picture above that there are two butterflies being analyzed. The top one is a regular butterfly with strikes equidistant to each other and $5 between each strike price. This structure will cost a debit of $0.58 cents per contract and will have defined risk of $0.58 cents per contract. That means that no matter the outcome, the max loss that can be incurred after purchasing this spread would be $58 for every contract that the trader buys.
The second butterfly below that is the broken wing. You’ll first note that the cost is much different. Instead of a debit, this spread trades for a credit which means that the trader will actually receive $0.04 per contract or $4 for every contract that they buy. This is made possible by the structure of the spread.
Every butterfly is simply one long vertical spread and one short vertical spread with the short part of each of those verticals being at the same strike. In our example above, the regular butterfly is a long vertical spread of 270/275 and a short vertical spread of 275/280. When put together as a butterfly, this trades for a credit because the longer spread is closer to the money and thus more expensive than the one that is further away from the money, creating a net debit to purchase the butterfly spread.
The broken wing butterfly is also made up of one long and one short vertical with the short parts at the same strike, however the short vertical is wider than the long. In our example above, the BWB is constructed from a long vertical of 275/280 and a short vertical of 275/285. This wider vertical trades for more than the more narrow one and when put together as a BWB, it nets out to a small credit which is how the trader is able to actually receive money from buying a spread.
What are the risks of a broken wing butterfly?
Since there is no such thing as a “free lunch” in the market, the broken wing butterfly does carry greater risk than the regular butterfly. Because the trader is essentially short a wider vertical than he or she is long, there is risk if the stock moves above the highest strike of the butterfly and all of the legs close in the money. Let’s look at both butterflies next to each other to more easily compare how they work as far as risk reward and possible outcomes. Again, refer to the picture above as we are using the two TSLA spreads as our examples.
| REGULAR BUTTERFLY | BROKEN WING BUTTERFLY | |
|---|---|---|
| Cost | $0.58 or $58 per spread | $0.04 credit or $4 per spread |
| Max Risk | $0.58 or $58 per spread | $4.96 or $496 per spread |
| Max Value | $5 or $500 per spread | $5 or $500 per spread |
| Max Value Price | $275 | $275 |
Let’s break down some of the nuances from the table above.
We’ve already gone over the cost. A regular butterfly will aways trade for a debit. A broken wind butterfly can trade for a credit but does not have to. It all depends on the structure and how wide the long vertical and the short vertical are. When constructing your BWB it’s advantageous to play around with multiple versions on the analyze tab of your trading platform to see how adjusting your strikes affects your risk and reward.
The maximum risk of the two butterflies is clearly different for the reasons stated above. The max risk of the BWB is the difference between the long and short verticals minus the credit received. In our example we received $4 to place the spread, however, the long vertical is $5 wide and the short is $10 wide. That means that our maximum risk is $4.96 which is $10 – $5 – .04. If TSLA was to be above $285 at expiry, our loss would be $496 for every spread we bought.
The maximum value of the two butterflies is the same as they both contain a long vertical that is $5 wide. If TSLA were to close right at $275 at expiry, then both the regular butterfly and the BWB would be worth $5 or $500 for every spread purchased.
The maximum value price is the price at which the spread would have the maximum value and in our examples this is $275 for both of them as that is the midstrike of both the regular and broken wing butterflies.
Things to know before putting on a broken wing butterfly
Selecting Options Series: The trader must first choose an options series that lines up with their time frame outlook for what they believe will happen with the stock. The advent of weekly options has created a lot of interesting scenarios where traders can use BWB’s to speculate on shorter term price movements and also exploit the accelerated theta burn that is characteristic of short dated options.
Do you want to collect a credit, capitalize on direction, or both?
As we hope you’ve figured out already, depending on how you choose the strikes of the broken wing butterfly, you can tailor it very specifically to what your objectives may be. If you are looking to simply collect a credit, then you may want to place your strikes in such a way that there are good odds that all strikes expire out of the money and you retain the entire credit you received when buying the butterfly. If you want to capitalize on direction, then you would place your strikes somewhere along the chain where you believe that there are good odds that the lower strike is in the money at expiry which would create a larger profit.
Advantages of the Broken Wing Butterfly Strategy
Defined Risk: This strategy provides traders with a clear understanding of their maximum potential loss upfront, making it a risk-defined strategy. This allows for better risk management and helps traders plan their trades effectively.
Cost Efficiency: As we’ve shown in our examples above, the broken wing butterfly can have the same potential maximum value at expiry but for far less cost, often even a credit received. This can be very profitable over time as situations where the trader is wrong on direction but has placed the spread at zero or negative cost won’t incur any losses.
Customization: Traders can adjust the strike prices of the butterfly wings to align with their market expectations and time frame outlook.
Conclusion
The broken wing butterfly options strategy is a versatile tool in the options trader’s arsenal. It offers defined risk and the ability to profit in multiple ways according to various movements in the underlying security. Traders can customize their broken wing butterflies in many different ways according to time to expiry, volatility of the underlying security, and what their objective is for the trade.
Traders should thoroughly understand this strategy, conduct proper analysis, and consider their risk tolerance before implementing it in their trading activities.
Note: Options trading involves risks, and it is important to educate yourself and consult with a qualified financial professional before engaging in options trading.
