From the September 01, 2011 issue of Futures Magazine • Subscribe!

Using the broken-wing butterfly options strategy

A better way

So far, we have seen the tremendous advantage that surgically placed option strategies offer for conventional stock trading. Stock traders are merely playing checkers while option traders are playing chess.

Yet, there are limitations to the butterfly spread. Most experienced option traders often have bought a butterfly spread only to see the market move outside its profit range and cause the trade to expire worthless.

In addition, butterfly spreads have a tendency to not open up and blossom until close to expiration. We know from the profit graph shown earlier that the butterfly spread is worth the most on expiration at the center strike. Yet, when there are weeks remaining prior to expiration, the butterfly will not come close to its maximum profit because of the stock's ability to move away from the center strike before expiration.

Though these limitations to the butterfly are small in comparison to its risk-adverse nature and its risk-adjusted return potential, they still can be frustrating. When you add the possibility that the stock could move so the spread goes out worthless to the mix, you may be wondering if there's a better way. Thankfully, there is.

Broken-wing butterfly

The goal of the broken wing butterfly (BWB) is to take advantage of the butterfly's benefits while minimizing its negatives. With the butterfly, the major negative is the initial debit paid for the position.

If we initiate a butterfly spread for a debit, we will want to figure out a way to eradicate the initial debit. In options trading, the only way to eradicate a debit is to sell something to bring capital back into the account. So if we sell a far out-of-the-money vertical spread that will pay for the butterfly, we now have on a position for zero cash investment.

When selling the vertical to bring in capital to offset the butterfly debit, we will want to find a spread that is as far out-of-the-money as possible while still bringing in enough of a credit to pay for the butterfly. Looking at the option chain on our Google example, we see that the best we can do is to sell the 500-495 put spread for a $1.40 credit ($7.90 - $6.50). Anything further out-of-the-money does not yield enough of a credit.

The ideal scenario is to have a short vertical spread that is statistically too far out-of-the-money to be reached by expiration. In effect, all we really do is pull the tail down one strike (see "Bending the butterfly," above).

<< Page 4 of 6 >>
comments powered by Disqus