Options strategy: Broken wing butterfly

January 31, 2010 06:00 PM

Many option traders swear by butterfly spreads as an inexpensive way to profit from an underlying closing in a predicted range. The downside to a butterfly is the total loss of capital when the stock or future closes outside the parameters that were set up by the chosen strike prices. We coined the “broken wing butterfly” variation as a powerful alternative to the butterfly with the goal of initiating the trade for zero cost. No more putting on put butterfly spreads only to see the underlying run higher causing a total loss of the debit premium, as it expires worthless.

A butterfly spread can be thought of as the simultaneous purchase of a long vertical spread and the sale of a further out-of-the-money (OTM) vertical spread sharing a common center strike and equal strike price separation. A broken wing butterfly (BWB) is the same as a butterfly; however, the sold spread is typically wider than the purchased spread. You can also think of a BWB as simply the sale of a ratio call or put spread with a far out-of-the-money tail incorporated into the mix for the purpose of risk and margin reduction.

As you compare the two OEX spreads in the above table, you will see that the traditional $10 wide butterfly on the left costs 90¢ and has the possibility of making as much as a $9.10 profit. However, the spreads often expire worthless, which would result in a $90 loss for every spread purchased. The BWB, however, can be initiated for zero premium. You also will notice that the BWB can be thought of as the purchase of a $10 put vertical (520-510) and the sale of a $15 put vertical (510-495).

You are trading one form of risk for another. In other words, you are ridding yourself of the 90¢ premium risk associated with the purchase of the traditional butterfly in exchange for a short far OTM put spread at the 500-495 strikes. The risk associated with the short spread is considered to be less than the risk of putting up 90¢. “A better mouse trap” will help you visually understand what is going on with the creation of the BWB.

Because the spread in this example was constructed using puts (although calls could have been used just as easily), the graph shows that the BWB will break even while the butterfly will lose the entire 90¢ investment if the market remains stable or advances higher. This is where the BWB has a distinct advantage over the traditional butterfly. We can see what the February options will look like in one month’s time by looking at the January options (see table below).

Notice that the purchased butterfly moves from 90¢ to $1.20 after the market remains stable for one month. Yet, the BWB has greatly outperformed the butterfly, moving from $0 to $1.10. The traditional butterfly appears to make only 30¢, while the BWB makes more than three times as much.

Should the market move down, both strategies can lose money at expiration, but the BWB can sustain a larger loss. That said, the break even on the BWB is better than on the butterfly, since it will offer more downside protection. In addition, the BWB has more durability to the downside than the break-even graph would suggest. Markets commonly fall below all the strikes, including the tails, and the position still may not lose money until expiration day.

There is an art and a science to selecting the right month, the right strike prices, and the correct distance away from the current price of the underlying. As a matter of fact, a whole book has been written just about the broken wing butterfly, which can be an invaluable strategy to add to your options tool box.

Alex Mendoza, chief options strategist with Random Walk, has produced numerous books and CDs on options trading. Visit their Web site, www.RandomWalkTrading.com.

About the Author
Alex Mendoza is the chief options strategist with Random Walk, which has produced numerous articles, books and CDs on options trading, including a book on broken-wing butterfly spreads. Visit their Web site:  www.RandomWalkTrading.com