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How To Set Up A Broken Wing Butterfly Option Strategy?

Published 06/06/2012, 08:23 AM
Updated 07/09/2023, 06:31 AM
A recent post on the blog here got a lot of comments about broken wing butterfly option strategies. Given all the hype and curiosity, I decided to put together a post that explored how you would set up this strategy specifically.

Oddly enough the broken wing butterfly isn’t a new strategy and has been around for years. Recently though it’s been gaining attraction for the simple fact that you can enter them without any investment or even at a credit – if you follow the plan below.

So, if you’re dying to know more about this lopsided creature then read on my friend!

The Original Butterfly Spread
It’s only right to quickly start at the beginning with your “typical” butterfly spread. The butterfly spread is created by selling 2 ATM calls and then at the same time buying 1 OTM call and 1 ITM call. This creates that famous peaked profit/loss diagram that you read about.
 
The goal with these is to capture a huge return should the underlying stock not move much between now and expiration. Of course this is rarely the case but if you can pin-point the closing price you’ll have a handsome profit.

Evolution Of The Broken Wing Butterfly
 
I guess you could say that the broken wing butterfly (BWB) was the new evolutionary step. Your typical butterfly had one major drawback (well 2 actually). First, you typically had to enter it with a debit from your account. Second, it strictly required very little movement in the underlying to make money.
Broken-Wing-Butterfly

You had to be dead right with this butterfly to see green. Not a friendly strategy if you ask me. Naturally traders started messing with strikes and quantities of contracts.
 
How To Set It Up?
 
Just like the original above, with a BWB you are going to sell 2 ATM calls and buy 1 ITM call. However this time you are going to SKIP over the next OTM call strike and move up 1 extra level. This creates spacing between the ATM call and the OTM call allowing you can capture more premium.
  1. Buy 1 ITM Call
  2. Sell 2 ATM Calls
  3. Skip A Strike
  4. Buy 1 OTM Call
By capturing more premium from the sale of the calls you can essentially enter the trade for either a very small debit or better yet, a credit to your account. How’s that for creative strategies!
 
With the additional upside potential you have to remember that you’ll also acquiring risk. You can’t necessarily give off risk without getting it back someplace else.

What’s The Goal With A BWB?
 
If you establish the trade for either a credit or very small debit the goal of course would be for the stock to close around the ATM strike OR BELOW by expiration. The ability for the stock to fall at the same time and still make money is the single unique feature offered by the broken wing butterfly.
 
A traditional butterfly would show a big loss should the stock fall before expiration. Now the stock can remain neutral and/or fall and you still make money. Again the trade-off being the bigger loss on the upper end should the stock rally violently. Start Paper Trading These Right Away
 
Like anything else you learn about in options trading, you should always start by paper trading the strategy first for a couple months before you put good money to work. Test this out in your favorite broker’s platform and have fun with it.
 
My goal as always is to introduce and help explain these strategies so that it’s easier for you to put them to work and finally start making some money trading.
 
As always, add your comments below any insights into how you’ve traded these BWB for better/worse…

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