What are the characteristics of this option strategy?
Broken wing butterfly spreads are butterflies with one wing deliberately widened, which lowers the cost of the structure and often turns it into a net credit. In call terms it is a long call vertical stacked against a short call vertical that is wider, sharing the same short strike: buy one call, sell two calls further out, then buy one call further out still, at a distance greater than the first gap. Risk and reward are both defined, but they are not symmetric. The maximum profit is the width of the narrow wing plus any credit received, realised at the short strike, while the maximum loss sits on the broken side and equals the difference between the two wing widths, less the credit or plus the debit. Compare the two before entering: in the worked example below the loss is $625 against a $375 maximum gain, and it is many times the credit a trader typically keeps when the stock finishes on the safe side. The high win rate this structure is known for is paid for with a small number of large losses. It suits traders looking to capitalize on a small move in the underlying asset.
Is this a bullish, bearish or neutral strategy?
The Broken Wing Butterfly is a neutral strategy, but it is more directional than a traditional butterfly because the widened wing skews the payoff. It is a limited risk strategy in the strict sense that the long outer strike caps the loss, but the size of that cap is set by the gap between the two wing widths, not by the premium paid. A trader who assumes the debit is the worst case will be badly surprised on the broken side. The reward is limited too, at the narrow wing width plus the credit received, or less the debit paid.
Is this a beginner or an advanced option strategy?
The Broken Wing Butterfly is an advanced option strategy. It requires the trader to have a deep understanding of the markets and options trading in order to be successful. Options involve more risks than stocks, and the Broken Wing Butterfly involves a more complicated setup and strategy than other option strategies. Knowledge of the Greek’s also is helpful when trying to strategize.
In what situation will I use this strategy?
The Broken Wing Butterfly is best used when the underlying is expected to drift toward the short strike and then stall there. The trade wants a small move, not a large one: a sustained run through the wide wing is exactly where the maximum loss lives, so the structure should be placed with the broken side facing the direction you consider least likely. Elevated implied volatility helps, since richer premiums on the two short contracts are what fund the wider wing and can turn the trade into a credit.
Where does this strategy typically fall in the range of risk-reward and probability of profit?
The Broken Wing Butterfly pairs a high probability of a small win with a low probability of a large loss. The maximum reward is the width of the narrow wing plus the net credit, or less the net debit, and it is only reached with the stock sitting at the short strike at expiration. The maximum risk is the difference between the wide wing and the narrow wing, less any credit received or plus any debit paid, and it is reached once the stock finishes at or beyond the far long strike. Work both numbers out before entering: in the example below the most you can make is $375 and the most you can lose is $625.
How is this strategy affected by the greeks?
The Broken Wing Butterfly strategy is affected by the greeks, particularly delta and theta. The delta of the strategy shows how much the position will gain or lose on any $1 move in the underlying security. Theta, or time decay, affects the strategy since all option contracts decay over time. It is important to be aware of how the greeks can affect the strategy so traders can adjust accordingly.
In what volatility regime (i.e VIX level) would this strategy be optimal?
The Broken Wing Butterfly strategy is usually opened in a high implied volatility environment, because richer premiums on the two short contracts let the trader collect a credit or reduce the debit. The catch is that high implied volatility is often high for a reason, and the same conditions that fatten the credit raise the odds of the move that carries the stock through the wide wing into the maximum loss.
How do I adjust this strategy when the trade goes against me? And how easy or difficult is this strategy to adjust?
Adjusting the Broken Wing Butterfly is manageable but not free. The cleanest repair when the stock runs toward the wide wing is to buy the missing wing, that is, to buy a call between the short strike and the far long strike, which converts the broken structure into a balanced butterfly or a condor and cuts the maximum loss back toward the debit. Rolling the whole structure in the direction of the move is the other common response. Both cost premium precisely when the position is losing, so position size on the maximum loss from the outset rather than relying on being able to adjust later.
Where does this strategy typically fall in the range of commissions and fees?
The Broken Wing Butterfly is low cost in premium terms, since the wide wing is what makes the structure cheap, but it is a four-contract order across three strikes, so commissions sit above a simple vertical spread. Fees depend on the broker and the quantity traded. Factor them into the risk and reward before entering, because they come straight off a maximum profit that is fixed.
Is this a good option income strategy?
The Broken Wing Butterfly is often used as an income strategy, since it can be opened for a net credit and wins more often than it loses. Treat the arithmetic honestly though: the loss on the broken side is a multiple of the credit, so a run of small wins can be erased by one move through the wide wing. Position size on the maximum loss, not on the credit received.
How do I know when to exit this strategy?
Traders should exit the Broken Wing Butterfly strategy when the underlying stock/ETF has moved beyond the breakeven points or if the trader is down to their maximum stop loss. It is important to stay aware of the underlying asset’s movements and to adjust the strategy as necessary.
How will market makers respond to this trade being opened?
Market makers treat this as ordinary spread flow and hedge the net delta rather than reading a view into it. On heavily traded underlyings with liquid strikes the combined quote is usually workable, but a three-strike order still means three bid-ask spreads, and the far wing is often the least liquid strike in the structure. Work the order rather than paying the posted spread, since the difference can be a meaningful share of the credit.
What is an example (with calculations) of this strategy?
Let’s take a look at a hypothetical example of a Broken Wing Butterfly with a purchase of one 50 call, the sale of two 55 calls, and the purchase of one 65 call. The wings are deliberately unequal, 5 points on the lower side against 10 points on the upper side, which is what makes it a broken wing rather than a standard 50 / 55 / 60 butterfly. The market is quoting a bid/ask of $1.00/$1.25. At the $1.25 ask the trade is opened for a net debit of $125.
The maximum reward is $375, the $500 distance between the 50 and 55 strikes less the $125 paid, and it is only reached with the stock at 55 at expiration. The break even points are at 51.25 and 58.75, so the stock must finish inside that range to show a profit.
The maximum risk is not the $125 debit. Because the upper wing is 10 points wide against a 5 point lower wing, a stock that finishes at or above 65 leaves the position short 5 points of intrinsic value that the long 65 call cannot recover: the two short 55 calls are worth 2 x $1,000 while the long 50 and long 65 calls are worth only $1,500 between them. That is a $500 structural loss, plus the $125 paid to open, for a maximum loss of $625 at any price of 65 or higher. Below 50 all four calls expire worthless and the loss is the $125 debit. So the worst case on the broken side is roughly five times the debit and larger than the maximum gain, which is the trade-off you accept in exchange for the wider profit zone.
How MarketXLS help?
MarketXLS provides tools and templates that make it easier to evaluate and implement the Broken Wing Butterfly strategy. With MarketXLS, traders can save time, optimize their risk-reward ratio and increase their chances of success. Some of the features include butterfly spread analysis, for both long and short butterflies as well as option pricing and greeks calculations. All of these features are designed to equip traders to make more informed decisions when trading the Broken Wing Butterfly strategy.
Here are some templates that you can use to create your own models
Search for all Templates here: https://marketxls.com/templates/