Options traders employ numerous strategies to achieve their goals in the market, and the broken-wing butterfly is a particularly useful technique to have at your disposal. This guide will explain the strategy in detail and show you how it can potentially be leveraged in various situations to take advantage of the market environment.
How Does the Broken-Wing Butterfly Work?
A Broken-Wing Butterfly (BWB) is a popular option strategy among advanced options traders due to its versatility. It’s a directional signal that can be more cost-effective than a straight vertical, and it can help traders avoid wasting strikes, which could ultimately result in lost premiums.
The “broken wing” refers to the asymmetric nature of the spread, where one long option creates a credit compared to the two short options. This keeps your initial investment smaller while allowing you to share in the possible gain of a volatile stock.
This strategy is a ratio spread with defined risk. It utilizes the broken wing’s widest out-of-the-money (OTM) wing to eliminate risk on the OTM side when trading for a net credit. It combines a debit spread and a credit spread with short options on the same strike, financing the cost of the debit spread portion of the trade. This net credit strategy increases the probability of profit (POP) without incurring upfront costs.
How to Set Up a Broken Wing Butterfly Options Trade
The Broken Wing Butterfly trade setup is a great options spread strategy to use in markets with high implied volatility (IV). This strategy is most effective when the underlying stocks have a high IV rank and percentage to maximize your potential profit.
Since the OTM side of the deal is no longer at risk, entering a BWB for credit increases your Profitability of Profit (POP). This strategy thrives on decreasing volatility, so keep an eye on market conditions.
How to Find Break-Even Points for BWB Trades
Break-even points are crucial for understanding your potential profit or loss. For BWB options, the break-even points occur when the underlying asset price reaches the strike prices of the short-call options.
To calculate a break-even point, you must consider the strike prices, premium paid, and commission fees. There are several online calculators that can help you determine the break-even point for your trade, but knowing the basic formula will give you a better understanding of the calculations in play..
For example, let’s take a BWB option with a short strike price of $160 and a long strike price of $162.5. If the premium paid is $1.70 per spread, your break-even point would be slightly higher than $160 and slightly below $154.20.
Advantages of BWB Options in High Volatility
For options traders, high volatility settings can be challenging. They have higher premiums but also have greater potential rewards. This is where BWB strategies excel.
BWB trades can help you lower costs compared to standard butterfly spreads.
For instance, a BWB option could be a good strategy for a stock experiencing significant price swings. This strategy would provide a defined risk profile, while still offering some directional exposure if prices move within a certain range.
Broken Wing Butterfly vs Standard Butterfly Options
The Broken Wing Butterfly strategy is similar to a standard butterfly trade, but there are a few notable differences between the two.
Structural Differences
Both Broken Wing and Standard Butterfly options have symmetrical wings, so the long calls or puts on either side of the short option have the same strike prices. On the other hand, BWB options have asymmetrical wings, meaning that the strike price of one long option differs from that of the other.
Risk and Reward Comparison
In terms of risk and reward, a standard butterfly spread offers higher potential profit if the underlying price lands precisely at the center strike at expiration, though it requires exact price movement to achieve this outcome. Conversely, the Broken Wing Butterfly (BWB) structure is unbalanced, allowing for a lower setup cost and often a net credit, making it a less risky choice. While the BWB’s maximum profit is typically lower, it can still yield small profits even if the price doesn’t hit the center strike, providing more flexibility with less precise price targeting.
Choosing the Right Strategy
Standard Butterfly options are better suited for a neutral market outlook, aiming to profit if the underlying asset price stays within a range. Conversely, BWB options allow for a capped risk, and they’re typically a better option if you want to favor price movements in a particular direction.
Choosing Strike Prices and Using Implied Volatility
Selecting the appropriate strike prices is critical for success with BWB options. Consider these factors:
Strike Price Selection
Your chosen strike prices define the profit zone where your BWB option becomes profitable.They also impact the cost of the spread.
Implied Volatility Considerations
Implied volatility reflects the market’s expectation of future price movements for the underlying asset. Higher implied volatility leads to higher option premiums. Before building your BWB option, examine the implied volatility to ensure the potential benefit outweighs the cost.
How to Choose Strike Prices
When considering strike prices for your options, consider your outlook for the market and your appetite for risk. Use a BWB option with a skewed long strike price that reflects your directional bias if you anticipate a slightly directional move.
Managing Risk with BWB Options
Risk management is crucial to achieving your trading goals. Here are some ways you can manage risk with BWB options:
Set Stop-Loss Orders: Implement stop-loss orders to exit the trade automatically if the price moves against your favor. If the market makes an unexpected move, this can help reduce possible losses.
Use Take-Profit Levels: Determine the take-profit thresholds based on your desired profit margin and risk tolerance. Once you reach your target profit, exit the trade to secure your gains.
Protective Collars: Use a protective collar if you want an extra layer of protection. This involves buying a deep out-of-the-money (OTM) put option and selling a deep OTM option to cap your potential losses and gains.
When to Use Broken Wing Butterfly Options
The Broken Wing Butterfly strategy excels when trading small, steady gains in low-volatility markets. Unlike conventional butterfly spreads, it can be profitable when share prices only move one direction.
Here are some of the best market conditions to effectively deploy a BWB trade:
Optimal Volatility Levels
BWB options can be particularly effective in moderate volatility environments. High volatility can potentially increase the cost of the spread, while low volatility can limit profit potential. For maximum profit potential in lower-volatility markets, pay extra attention to strike prices,market trends, asset volatility, and expected price movements.
Underlying Asset Price Trends
Both trending and range-bound markets are suitable for using BWB options. However, they work better in range-bound markets, meaning that the underlying asset is expected to remain within a given range.
Time to Expiration
The price and possible profit of a BWB option might change depending on how long it takes to expire. Longer expiration periods typically demand greater premiums, but they also allow more time for your trade to play out.
Broken Wing Butterfly Trade Example
The best way to wrap your head around this strategy is to see it in action. Here’s a typical BWB setup:
- Buy a call or put above the short strike
- Sell two calls or puts at the short strike
- Buy a call or put below the short strike
Broken Wing Butterfly Trade Example
In this video, I break down the structure and mechanics of the broken-wing butterfly (BWB) options spread, highlighting how it differs from a standard butterfly by adding a directional bias. This adjustment makes the BWB especially useful in high-volatility environments, allowing for controlled risk while capturing profit potential.
For this example, I use Qualcomm (QCOM) with an April 14th expiration and strike prices at $150, $145, and $143 to demonstrate a bearish broken-wing butterfly setup:
- Underlying Stock: Qualcomm (QCOM)
- Expiration: April 14th
- Strike Prices: $150, $145, $143
- Expected Move: Approximately $8, based on combined premiums
- Target Strike for Bearish Bias: $145
To construct the BWB, I start by:
- Buying a Long Put Spread at $150 and $145.
- Selling a Narrower Put Spread at $145 and $143.
This setup skews the position slightly bearish by having an uneven width in the spreads, which lowers the entry cost and aligns the profit potential with a move toward the $145 target. The broken-wing butterfly structure is an excellent way to manage risk while allowing for gains even if QCOM moves past the final strike, unlike a traditional butterfly, which would lose value in such cases.
This approach shows how a BWB can provide a directional edge in high-volatility scenarios, making it a versatile choice for traders who want to manage exposure while still pursuing profit.
Common Mistakes to Avoid
A lot of traders get caught in traps with broken-wing butterfly options. Here are four common mistakes to avoid.
Overestimating Profit Potential
While BWB options have the potential to yield profits, it is important to keep in mind that this potential is limited. Set reasonable profit targets that take into account the volatility of the underlying asset and the state of the market, and refrain from overestimating the possible returns.
Underestimating Risk
Despite having a defined maximum loss, BWB options are risky. Don’t underestimate the potential for losses if the underlying asset deviates considerably from the intended range. Keep up with market developments and be ready to modify your position as necessary.
Ignoring Implied Volatility
Increased spread costs and possible loss can result from higher implied volatility. After evaluating the option’s pricing, modify your approach based on the implied volatility data.
Lack of Discipline
Adhere to your trading plan and refrain from making impulsive decisions. For efficient risk management, stay within your stop-loss and take-profit boundaries. Avoid chasing profits or trying to time the market, as this can lead to costly mistakes.
Closing Thoughts on the Broken Wing Butterfly Trade
The Broken-Wing Butterfly gives traders a great balance of potential reward and defined risk when the significant variables are known, risks are controlled effectively, and market conditions are appropriate.
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Originally Posted December 6, 2024 – The Broken-Wing Butterfly: A Hidden Gem in Options Trading
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Options involve risk and are not suitable for all investors. For information on the uses and risks of options, you can obtain a copy of the Options Clearing Corporation risk disclosure document titled Characteristics and Risks of Standardized Options by clicking the link below. Multiple leg strategies, including spreads, will incur multiple transaction costs. “Characteristics and Risks of Standardized Options”