A Better Butterfly – Broken Wings Fly Further
Alex Mendoza – Chief Options Strategist
RandomWalkTrading.com
Traditional butterfly spreads have been around since the 1970's for good reasons – they are easy to manage, have an excellent risk-reward ratio, and enjoy the ability to surgically place trades at key technical numbers. The only downside to butterflies is that you will lose the entire premium which you paid for the spread if the underlying closes outside of the extremes on expiration.
There is a derivative that is far better than the butterfly which is known as “Broken Wing Butterflies,” or “One Strategy For All Markets.” The thinking is simple – if you can create a spread with all the benefits of a butterfly and without a cost or debit, then you have created some magic. Since all of Random Walk's instructors are retired members of the Chicago Board Options Exchange who traded variations of butterflies, the BWB has become one of the many staples for which we are famous.
Broken Wing Butterfly (BWB) Definition
A broken wing butterfly is the simultaneous purchase of one vertical spread and the sale of a slightly wider and further out-of-the-money (OTM) vertical spread which share a common center strike. You can think of the BWB as a traditional butterfly where the protective tail (either call or put) is pulled slightly further OTM.
Compare the BWB to the garden variety butterfly, and let its strengths speak for themselves. The following option chain shows the closing marks for the Standard & Poor's 100 index – the OEX (February 17, 2010) – but we could have used the option chain from almost any day's prices of any index or stock. A call BWB in GOOG would have been just as good. See IMAGE 1.
Traditional $10 Put Butterfly
The spread on the left is the standard textbook butterfly that is going for a $0.65 debit. It translates to a $650 debit on 10 contracts ($0.65 per share X 100 multiplier X 10 contracts). This poses a very real and considerable risk if the market does not decline to our chosen strikes. Although the potential profit on this trade $9,350 ($10,000 maximum profit - $650 investment) is very attractive, how many times have you had a market go in the opposite direction than what was anticipated?
Put Broken Wing Butterfly
The next spread shows how the spread has gone from a $0.65 debit to a $0.05 credit by simply splitting the tail strike down from 480 to 475. If the stock market declines now, we are set up to make a nice profit, and if the market stays steady or runs higher, we do not face a loss. We have added some level of risk by turning the traditional butterfly spread into a broken wing butterfly, but the risk is smaller than it would seem.
There are many reasons why the BWB has great durability against adverse market movement, but because of space constraints, we will limit our explanation to the most obvious and irrefutable argument – delta. As you can see below, the net delta of this position is negligible. The delta can and will change as time approaches expiration, but we have developed ways to take advantage of this and adjust when necessary. See IMAGE 2.
Graph
We have included a profit and loss graph to compare the overlapping BWB and normal butterfly at expiration. At first glance, the broken wing butterfly may seem to have more downside risk, but please notice all the other areas on the chart where the break-even is far superior to the traditional butterfly spread. We give a more detailed explanation concerning the real dynamics of the BWB prior to expiration in our textbook, One Strategy for All Markets.
Market Direction
From here the market can move in several directions – up, down, or remain stable.
Higher
If the market moves higher at expiration, the spread will expire worthless. Instead of having a $650 loss with the traditional butterfly, you will now get to keep the $50 credit, which will probably go to your broker.
Stable
If the market remains stable, the BWB will expand just like a normal butterfly, but usually to an even great extent.
Market Declines Moderately
With a slight downdraft, the position become the proverbial home-run, capable of making up to $10 plus the net credit per share.
Market Declines Rapidly
This spread has one negative. A loss can occur if the market dramatically collapses. Keep in mind that these spreads are at the worst price for their given time to expiration periods, and under normal circumstances, they will slowly get better with each passing day. If a 3 sigma type move occurs, our students will learn techniques to adjust before serious losses happen. See IMAGE 3.
Conclusion
Although there appears to be an increased level of risk associated with the broken wing butterfly compared to the traditional butterfly, most of our students agree that that risk can be minimized. It is negligible compared to the risk of paying large debits for spreads that often go out worthless. Our retired market-makers concur that the BWB is vastly superior to the butterfly. Learning this strategy will be a profitable time investment for you in the long run.
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