Broken Wing Butterfly Options Strategy: A Path to Trading Success

Have you ever watched one of those time lapse videos where a caterpillar turns into a butterfly?

The captivating event isn’t always flawless. Sometimes a wing fractures, pushing the butterfly to modify its flight pattern. This scenario aptly mirrors the journey ventured upon in the dynamic world of options trading.

The Broken Wing Butterfly strategy serves as a potent symbol of resilience amidst shifting market tides. This advanced strategy calls for an equilibrium between strategic adjustment and balance, the same as a butterfly that adapts its flight with a broken wing. More than just surviving in the tempestuous market atmosphere, it thrives, turning unpredictability into a strategic asset.

But how does this strategy weather the oftentimes stormy financial market winds? And how does it stand up to other options strategies like the formidable credit spread? We’re about to delve into these intriguing queries, highlighting the unique charm of the broken wing butterfly strategy for traders worldwide.

Quick Overview of Options Trading Basics

Options trading may seem complex to unseasoned investors, but its fundamental concepts can be distilled to simple terms. It is a powerful financial instrument, provided the risks and rewards are thoroughly understood.

Options, to start with, are contracts that allow an investor the right, but not the obligation, to buy or sell an asset at a set price, known as the ‘strike price’, within a specific time period or before a specific date, referred to as the ‘expiration date’. The expiration date is essentially the deadline for the holder of the option to exercise their right to buy or sell. They are classified into two broad categories: ‘call options’ and ‘put options’. 

Call Options

Imagine having the right to buy a stock at a fixed price within a certain timeframe. This is precisely what a call option offers. It empowers an investor to purchase an asset at a set price before the contract expires. The crux of it is that investors can leverage this option if they anticipate a surge in the stock’s value—similar to the way $NVDA led the AI rally by soaring 24% in May.

Put Options

On the flip side, a put option grants the investor the right to sell a stock at an agreed-upon price within a specific time period. Investors can benefit from put options when they predict that the value of the stock is going to decline.

Strike Price

The ‘strike price’, also known as the exercise price, is a crucial concept in options trading. It is the predetermined price at which an investor can either buy (in the case of a call option) or sell (in the case of a put option) the underlying security.

Overall, options trading, while multifaceted, can unlock potential profits, shield from price shifts, and cultivate income. However, as the old adage goes, with great power comes great responsibility. A key part of learning how to trade options is understanding the danger, as the risks involved in options trading are just as significant as the benefits. Without careful comprehension and strategic planning, an investor can quickly incur significant losses, potentially exceeding their initial investment, particularly with margin trading.

This brief primer lays the groundwork for more intricate strategies like the “Broken Wing Butterfly”. Employing the core principles of options trading, this strategy offers a distinct balance of risk and reward. Ready to unfurl its wings?

What is a Broken Wing Butterfly Strategy?

The broken wing butterfly, also known as a “Skip Strike Butterfly”, is an options strategy used by advanced traders, arising from the realm of ‘wingspreads’. This strategy is tailored towards investors looking to profit from a specific price range of the underlying security or to set up a low-risk, high-reward position.

At its core, the broken wing butterfly strategy consists of three option strike prices, unlike the standard butterfly spread which entails an equal distance between all strike prices. This strategy incorporates a bullish or bearish slant to the traditional, symmetrical ‘butterfly spread’, hence the name “Broken Wing”.

The key objectives of employing this strategy are:

1. Capitalizing on a specific price range: The broken wing butterfly strategy offers investors the chance to reap maximum profit if the price of the underlying asset remains within a specific range.
2. Creating a low-risk, high-reward position: If the price of the underlying asset moves beyond the anticipated range, the potential loss is typically capped and often less than what can be achieved through other strategies.

The distinguishing characteristic of the broken wing butterfly strategy is the uneven spacing of the strike prices. The unequal ‘wings’ (depicted in the image below) allow the investor to adjust their risk exposure, either to the upside or downside, depending on their market outlook. This flexibility is a unique attribute of the broken wing butterfly, setting it apart from other options trading strategies.

While it can be a tad more complicated to set up compared to other strategies, the broken wing butterfly’s blend of risk and reward can make it a compelling choice for seasoned investors seeking to play the odds in a controlled manner. Its implementation requires a nuanced understanding of options trading, but with some practice, it can become a valuable tool in an investor’s arsenal.

Profit-Loss graph of a Broken Wing Butterfly options strategy, illustrating the range of potential profits and losses based on the underlying asset price. The horizontal axis represents the price of the asset, while the vertical axis shows the corresponding profit or loss.

Constructing a Broken Wing Butterfly Trade

The broken wing butterfly trade’s strategic allure lies in its structure: an arrangement of options around three strike prices. When setting up this trade, a methodical approach is crucial, and each decision impacts the risk-reward balance. 

First thing you want to do when setting up a broken wing butterfly is identify the underlying asset. Namely, before launching into any options strategy, it’s necessary to identify the underlying asset. Thorough research and analysis of the asset’s potential performance and volatility are essential to this decision.

The next step is to formulate a market outlook. Are you anticipating a rise (bullish) or a fall (bearish) in the price of the asset? Your market outlook will determine the type of options used – calls for a bullish outlook and puts for a bearish outlook.

Next you want to set up your options and strike prices. In a broken wing butterfly trade, you’ll be dealing with three strike prices – let’s call them A, B, and C. This is where your strategy starts to take form:

• Option at Strike Price A: This is your first option, bought at the lowest strike price (A). It is typically ‘In the Money’ (ITM) or ‘At the Money’ (ATM).
• Options at Strike Price B: Here, you sell two options at strike price B, which is higher than A. This strike price is usually ATM, thus it tends to bring in a good premium to offset the cost of the other two options.
• Option at Strike Price C: Lastly, you purchase one option at strike price C, which is higher than both A and B. This option is typically ‘Out of The Money’ (OTM).

Lastly, you want to align your expiration dates. In a broken wing butterfly trade, all options should ideally share the same expiration date. The selection of this date requires a delicate balancing act, as longer timeframes can allow more room for the asset to move within the desirable range, but simultaneously escalate the cost of the options.

With the above steps, your broken wing butterfly trade is set up and ready to take flight.

Profit & Loss and Risk Management

So far we’ve established that the broken wing butterfly strategy allows investors to establish a position with a high potential return and a limited risk, but it’s essential to remember that like all option strategies, it comes with a unique set of risks. We’re going to highlight here the key profit and loss factors of the broken wing butterfly. 

Potential Risks

1. Adverse Price Movements: If the price of the underlying asset moves significantly beyond strike price C or falls below strike price A, the trade could result in a loss. However, due to the structure of the broken wing butterfly, the loss is still capped at the initial cost of setting up the trade.
2. Time Decay: As with all options strategies, time decay, or theta can impact the profitability of a broken wing butterfly trade. If the price of the underlying asset does not reach the desirable range by the expiration date, the options may expire worthless.
3. Changes in Implied Volatility: A significant increase in implied volatility can inflate the premium on options, potentially eroding profits or increasing losses. Conversely, a decrease in implied volatility can reduce the potential profitability of the strategy.

Potential Rewards

1. Profit from Price Stagnation: The broken wing butterfly strategy can yield maximum profit if the price of the underlying asset is at or near the middle strike price (B) at expiration. This makes it an excellent strategy in a range-bound or low volatility market where substantial price movements are not expected.
2. Limited Risk: One of the most appealing aspects of this strategy is its defined risk. Regardless of how drastically the price of the underlying asset may change, the maximum possible loss is the initial net debit taken to enter the trade.
3. High Potential Return: If executed correctly and the price of the underlying asset lands at the middle strike price (B) at expiration, the potential return can be quite substantial compared to the initial investment. 

Example of Broken Wing Butterfly

To understand the broken wing butterfly strategy more clearly, let’s walk through a hypothetical example. Assume that an investor is anticipating moderate upward movement in the stock of Bank of America (BAC), trading at $30 .

Broken wing butterfly setup:

• Buys one ITM call option with a strike price of $25 (A) for a premium of $7.
• Sells two ATM call options with a strike price of $30 (B) for a premium of $3 each.
• Buys one OTM call option with a strike price of $40 (C) for a premium of $1.

The total premium paid is $7 (for the option at A) + $1 (for the option at C) – $6 (collected for the options at B) = $2. This is the maximum risk or maximum loss for this trade.

Here’re the possible scenarios at the options’ expiration:

• If BAC is below $25 or above $40, the investor loses the net premium paid ($2).
• If BAC is at $30 (Strike B) at expiration, the investor gains the maximum profit. The profit is the difference between A and B ($30 – $25 = $5) minus the net premium paid ($5 – $2 = $3).
• If BAC is between $25 and $30 or between $30 and $40 at expiration, the profit or loss depends on the exact price. However, the loss will never exceed the initial net premium paid ($2).

This example should solidify how the broken wing butterfly strategy really works. If you’re still curious how this works, or would like to see similarly advanced options strategies at play, consider subscribing to swing trading alerts for options trading. Many services provide alerts of interesting options trading setups, allowing subscribers to learn directly from experienced, veteran traders. 

Pros and Cons of Broken Wing Butterfly

Pros

• Limited Risk: One of the main advantages of a broken wing butterfly strategy is that the maximum possible loss is defined and limited to the net premium paid to establish the trade.
• High Potential Returns: If the price of the underlying asset lands at the middle strike price at expiration, the potential return can be substantial relative to the initial cost.
• Flexibility: The strategy can be employed in both rising (bullish) and falling (bearish) markets, using either call or put options, adding to its versatility.
• Profit from Non-Movement: This strategy can generate profits even if the price of the underlying asset doesn’t move significantly, making it a suitable choice in a range-bound or low-volatility market.

Cons

• Complexity: The broken wing butterfly is a complex strategy involving multiple options contracts at different strike prices. It requires a thorough understanding of options and may not be suitable for beginners.
• Risk of Small Losses: While the risk is limited, there is a higher probability of a small loss if the price of the underlying asset does not reach the desirable range by the expiration date.
• Transaction Costs: The strategy involves setting up multiple options contracts, which can lead to higher transaction costs that may eat into the potential profits.
• Impact of Volatility: Changes in implied volatility can significantly influence the profitability of the strategy. A sharp increase can inflate the premium on options, potentially eradicating profits or amplifying losses.

Broken Wing Butterfly vs. Credit Spread

Both the broken wing butterfly and the credit spread provide investors with a defined-risk mechanism to potentially garner profits, but they come with their unique nuances. 

Let’s start with the broken wing butterfly. This strategy is built using two short options and two long options, with one each above and below the short strike price. The trade’s maximum profit is the width of the debit spread part of the trade, less the debit paid, or plus the credit received on trade entry.

To achieve this maximum profit, the stock must land on your short strike at expiration. On the other hand, the maximum loss is calculated as the width of the credit spread, minus the width of the debit spread, and minus the credit received upfront or plus the debit paid upfront. Given its intricate nature, this strategy thrives in a high implied volatility (IV) environment. 

Contrastingly, a credit spread is set up with a long and a short option contract at different strikes, with the short option trading at a higher premium than the long option. It offers either call options when the market assumption is bearish or put options when it’s bullish. The maximum profit here is the credit received upfront for selling the spread.

You can’t earn more than the initial credit received, and to hit max profit, the spread needs to expire out of the money (OTM). The max loss is the width of the credit spread minus the upfront credit received. Similar to the broken wing butterfly, this strategy also performs well in a high IV environment. 

While both strategies have their benefits, the decision to employ either largely depends on the investor’s market assumption and their risk-reward comfort zone. A broken wing butterfly might appeal to those who wish to position their max profit and risk to either the upside (calls) or downside (puts). On the other hand, investors who have a strong bearish or bullish market assumption might gravitate towards a credit spread. 

Conclusion

The broken wing butterfly, in its delicate flight, embodies the intricate dance of options trading, where understanding the forces at play can lead to profitable ventures. It’s an advanced strategy that calls for meticulous planning and execution, a discerning eye on market conditions, and a steady hand to manage risks and potential rewards. Like the butterfly navigating through the breeze, a seasoned trader navigates the ebbs and flows of the market using the broken wing butterfly strategy.

In the world of options trading, the broken wing butterfly strategy, much like its credit spread counterpart, allows for a controlled dance within the winds of market volatility. A proficient understanding of these strategies provides a seasoned trader with the ability to float effortlessly in the market, akin to the flight of a butterfly. However, also like our butterfly, they demand a delicate balance and the ability to adapt to changing conditions. As the butterfly dances with the breeze, so does a trader dance with the market. Embrace the dance, and the market might just join in, and dance with you. 

Trading the Broken Wing Butterfly: FAQs

Is a Broken Wing Butterfly Strategy Considered a Bullish or Bearish Strategy?

A broken wing butterfly strategy can be either bullish or bearish, depending on how it’s implemented. If the investor sets up the strategy such that the strike prices are above the current market price of the underlying asset, the strategy is considered bullish, as it profits from a rise in the price. Conversely, if the strike prices are set below the current market price, it’s bearish, as it profits from a price decrease. 

What’s the Maximum Profit of a Broken Wing Butterfly Strategy?

The maximum profit for a broken wing butterfly is calculated as the difference between the highest and middle strike prices, minus the initial net debit or plus the initial net credit established when opening the trade. Since one of the spreads is wider than the other, this will result in a net debit (cost) or credit (income) at the time of the trade. Note that transaction fees also play a role, and they should be taken into account when calculating profit potential. 

What’s the Purpose of a Broken Wing Butterfly?

The purpose of a broken wing butterfly strategy is to establish a position that has a defined risk profile but an asymmetric return potential. It’s often used when a trader has a directional view on the market, but also wants protection against adverse price movements. In particular, the broken wing butterfly provides a larger margin of error on one side of the market (the ‘broken’ side), giving the trader more room for the underlying asset’s price to move without causing a loss compared to a traditional butterfly strategy. 

Is the Broken Wing Butterfly Strategy Recommended Only for Experienced Options Traders? 

While it’s not necessarily limited to advanced options traders, the broken wing butterfly strategy does require a more nuanced understanding of options trading than basic strategies such as calls and puts. This is because the trader needs to understand how to construct the position using multiple options contracts with different strike prices, and also how to manage and adjust the position over time. Therefore, while it’s not solely for advanced traders, it’s best used by those who have a solid understanding of options, their risk/return profiles, and how they can be combined to achieve specific objectives.