For decades, many astute option traders have relied on a modified butterfly spread either to supplement or ignite their monthly incomes. The broken-wing butterfly (BWB) is an advanced option strategy that builds on the traditional positive traits of the well-known butterfly spread. To understand the intricacies of this technique, it's important to start with the basics. Here, we'll lay the foundation and then build to some BWB examples in the equity options market.
Using a hypothetical opinion derived from looking at "GOOG and gone" (below), a trader could come to the conclusion that Google Inc. (GOOG) is headed down from the mid-July level of $536 to its nearest support. We would peg that support near $515 based on our proprietary statistical formula.
Until learning options, a trader may simply sell the stock short to profit from this opinion. This obviously comes with a lot of risk and a high margin cost. First, if the trader sells the stock short, the risk is virtually unlimited to the upside, even if a stop order is in place. Second, selling even 100 shares of GOOG short will require the trader to put up half of the stock's value, or $26,800 (one-half margin * stock price of $536 * 100 shares).
Once a trader learns option basics, he often will forgo selling stock short in favor of buying a more limited-risk naked put. For the remainder of this article we will assume the option chain shown in "Chain gang" (below) that is based on volatility at 30.6% with 38 days until expiration.
In "Put it to 'em" (right), we see that when the stock is trading at $536, we can purchase the right to sell it at the 530 strike instead of selling the stock short. The cost of this put is $18.10 and we will control the same 100 shares of stock that we were looking to short.
When considering the sale of the stock, we had to put up $26,800, but the cost of one put contract trading at $18.10 will require an investment of only $1,810 ($18.10 per share * 100 shares per contract). Because of the lower cost of entry and substantially reduced risk, many traders prefer to purchase the put for $18.10. Obviously we would want to exercise that right only once the stock moves considerably in our direction.
Spreading the risk
There is investment risk in buying a naked call or put, but by spreading that risk, we can have a more viable strategy. Instead of buying the 530 put naked, you can enhance the position by selling another put at the area you think the stock will stop — in this case, it is the 515 put (our support area).
When buying the 530 put for $18.10 and selling the 515 put for $12.30, you now have on a position costing only $5.80 per share ($18.10 - $12.30). Here, we can make up to the difference between the strike prices of $15, minus the cost of the spread, $5.80. This allows us to have a profit potential of $9.20 on an investment of $5.80 (see "Limiting risk," right).
We still want to trade the equivalent of 100 shares of stock, but our costs have gone way down. If we elected to sell stock short, the cost would be $26,800. With a long put, it would be $1,810. Now, with the put spread, our cost is only $580.
Next in their option strategies education, most traders realize that cost and risk are reduced with the vertical spread by buying one option and selling another. So why not buy one spread and sell another? This is the butterfly spread.
The butterfly spread can be defined as the simultaneous purchase of the vertical spread (call or put) and the sale of the same size further out-of-the-money vertical spread where both spreads share a common center strike.
To explain, we know that the 530-515 put spread costs $5.80 per spread. The 515-500 vertical spread is the same size ($15) spread that is further out-of-the-money. The sale of this spread would bring in $4.40 ($12.30 - $7.90) and help offset the $5.80 cost of our long spread. The butterfly would thus cost us $1.40 (long 530-515 put spread $5.80 debit — short 515-500 put spread $4.40 credit). This is shown graphically in "Butterfly bonus" (right).
We know that if we sell a spread that is further out-of-the-money than the spread we bought, then we can't lose money on the short vertical spread without first making money on the spread that is closer to at-the-money. We are therefore well protected.
We also have taken the cost of entry down from $26,800 to $140:
Strategy Trade outlay
Short stock $26,800
Long put $1,810
Long put vertical $580
Long butterfly $140
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).
Costs and benefits:
- We have reduced the cost of the butterfly to a net-zero debit.
- We have added some risk by being short a $5 spread, but that risk is far out-of-the-money.
- The risk we did pick up can be considered by most to be insignificant compared to the risk we have when we buy a butterfly for a debit.
The main argument against the BWB is that the short spread does add risk to the position. Yet, if the spread is sold far out-of-the-money, then it has a small statistical chance of going in-the-money. Most traders consider it a great trade off.
For example, when the stock is at $536 and you buy a traditional butterfly for $1.40, you have risk. You have $1.40 per share of risk. If the stock does not sell off below $533.60 (the breakeven point), then you will lose some or all of your initial investment. If the stock remains unchanged until expiration, you will lose your initial investment. And if the stock runs higher, you will lose your initial investment.
Yet, with the BWB, you will not lose anything unless the stock closes at $500 or lower on expiration. Because the BWB has a potential risk of $5 but saves us $1.40, we are really trading a realistic chance of losing $1.40 for a small chance of losing $3.60 ($5.00 - $1.40).
Remember our example assumed a short bias on Google on July 13. Two days later, after the market initially moved in our direction, earnings were announced and Google spiked nearly $70 higher (see "A ton of risk," above). If we simply had taken a short position, our stop would have been blown away and the hypothetical trader would have faced major losses. With the BWB, there were no losses, other than commissions, despite being wrong the market.
The BWB is a popular strategy for professional traders, and now you can add its value to your portfolio.
M. Burkhardt is the CEO of Random Walk LLC, an educational company. You can reach him via RandomWalkTrading.com.
For more on the Broken Wing Butterfly, check out these articles:
Futures introduces the Broken Wing Butterfly
Options strategy: Broken wing butterfly
Ride bullish trends with unbalanced broken wing butterfly options
