Broken Wing Butterfly Spreads – Everything You Need To Know

Hey everyone – Scott Bauer from Prosper Trading Academy here. In exploring advanced options strategies, it’s crucial to understand how variations can be applied to tailor risk and reward. Today, I’m going to share insights on a unique options trading approach called the Broken Wing Butterfly. This strategy is a twist on the classic butterfly spread, allowing for more flexibility in directional trading. It’s essential for traders to realize that a Broken Wing Butterfly can be structured whether you hold a bullish, bearish, or neutral outlook on the market.

I recently delved into a bearish Broken Wing Butterfly trade on QCOM as an example. Normally, a butterfly spread maintains symmetrical strike distances, but the magic of the Broken Wing Butterfly lies in its asymmetry. Intentionally skewing the strikes allows for a strategic bias while still defining maximum risk. By adjusting the strike widths, I can influence the trade’s delta, capturing more profit potential when predicting directional moves. It’s a delicate balance of position structure and strike selection that can lead to favorable outcomes even if the stock moves beyond the anticipated range.

Key Takeaways

• A Broken Wing Butterfly adjusts traditional butterfly spreads for directional bias, with asymmetrical wings for flexible risk management.
• Strike selection and pricing in a Broken Wing Butterfly are critical, aiming to maximize profit at the short strike with defined risk parameters.
• The strategy provides a safety net by retaining value even if a stock surpasses our target, differing from symmetrical butterflies that become worthless beyond the furthest strike.

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UNDERSTANDING THE BROKEN WING BUTTERFLY SPREAD EXAMPLE

I’m going to walk you through why someone might opt for an asymmetrical butterfly spread, commonly known as the broken wing butterfly. This strategy is adaptable to different market sentiments—I could go bullish, bearish, or stay neutral. This distinction from the typical butterfly position really opens up a wealth of strategic choices, regardless of the market direction I’m anticipating.

When I construct a traditional butterfly spread, I’m dealing with a symmetrical 1:2:1 ratio—the outer parts of the butterfly, or ‘wings’ as they’re sometimes referred to in trading jargon, are equally distant from the ‘guts’ or the middle strikes. For a quick refresher, if the long option is $5 wide, so would be the short, creating a mirrored setup.

Now, pivoting to the broken wing butterfly setup, it’s all about directional bias. Here’s the thing: the wings are no longer symmetrical. Even though the ratio stays put at 1:2:1, ensuring I’ve got my maximum risk nailed down, the spread between the long and short strikes skews, giving me a more directional tilt.

Let’s consider a hypothetical scenario with stock “QCOM.” Suppose QCOM is priced at $152.50 and has a projected move of $8 by April 14th. If I’m bearish, I’d be looking at a target around $144.50 come expiration.

Let me illustrate with numbers. Say I’m constructing a bearish broken wing butterfly spread. Instead of going for a symmetric $150-$145-$140 spread, which would be the classic butterfly approach, I’d go asymmetric. I might opt for a spread structured like $150-$145 long and $145-$143 short. This would be wider on the long side and narrower on the short side—in essence, broken.

Here’s why this gets interesting—usually, with regular butterflies, if the stock price blows past my lowest strike, the spread may be worthless. But with the broken wing variation, I preserve value even when the stock exceeds the lowest strike.

• Long spread: 150-145, $5 wide
• Short spread: 145-143, $2 wide
• Result: Not symmetrical, preserving value if stock dips beyond the lowest strike

For example, if I buy a 150-145-143 broken wing butterfly and pay around a dollar, nothing gained if the stock is over $150 at expiration—all options expire worthless. If QCOM hits $147, my long 150-145 would be worth $3, and the short spread is nil; thus the butterfly’s worth is $3. At 145, it peaks at $5. Now, here’s the kicker—below 145, I wouldn’t lose it all. Even at $143, the setup would net me $3, which is superior to a traditional butterfly where any price underneath the lowest strike could bring the spread’s value to naught.

In essence, by crafting a broken wing butterfly, I’m paying a bit more upfront for increased chances at profit if the stock tumbles past my anticipation. It’s about managing expectations and preparing for surprises, whether they are detrimental or not—pretty neat, right?

VARIATIONS IN THE BROKEN WING BUTTERFLY OPTION SPREAD

When configuring a Broken Wing Butterfly, I’m manipulating the spread to be directionally biased. This strategy deviates from the standard Butterfly through the asymmetry of its outer strikes, or “wings,” relative to the middle, or “guts.”

Key Characteristics of the Strategy

• Position Ratios: The position maintains a 1:2:1 ratio, necessary for defining maximum risk. Equal numbers of long and short options are essential for this balance.
• Strike Widths: Unlike a symmetric Butterfly with evenly spaced strikes, the Broken Wing version has unequal widths. For instance, if I’m looking at a bearish setup on a stock like QCOM, I’d set up the spread considering its expected move—let’s say an $8 shift anticipated by the April 14th expiration, pushing down from $152.50 to target around $144.50.Here’s a comparison in a tabulated format:Spread ComponentsRegular ButterflyBroken Wing ButterflyLong Spread Width$5$5Short Spread Width$5$2Ideal Target Strike$145$145Cost of the Spread~$0.70$1.00 – $1.05
• Directional Bias and Value: The Broken Wing Butterfly tilts directionally for an increased delta, which means it’s poised to benefit from the stock moving towards my short strike. A critical distinction with this spread is that it retains value even if the stock moves beyond the lowest strike.

Practical Example with Pricing

To illustrate, my Broken Wing setup might involve buying a 150/145/143 spread for about a dollar. As long as QCOM stays above $150, the spread expires worthless. If QCOM hits $147 at expiration, the long spread is worth $3 while the short spread is zero, valuing the entire position at $3. Even if QCOM plunges past my lowest option strike, the position never drops below $3 in value, whereas a traditional Butterfly would be worthless in such a scenario.

So, creating a Broken Wing Butterfly allows for a more directionally biased play, where I’m anticipating a stock move toward a specific strike, albeit with a safety net if the stock overshoots my expectations. This flexibility does come at a higher initial cost, but it also provides additional security on extreme moves.

ADJUSTING STRATEGY FOR DIRECTIONAL BIAS

Offset Positioning for Directional Bias

When I construct my trade with a bias in mind, I intentionally design the spread to not be even on both sides of the central strikes. Even though I maintain the fundamental 1:2:1 setup, the aim is to extend the length of the spread on one side to align with my market sentiment, which could quite easily be bullish or bearish. As an example, if I’m sensing a downward trend, rather than an evenly spaced set such as the strikes of $150, $145, and $140, I would look to set it up more like $150, $145, and $143. This way, the upper spread remains $5 wide, but the downside narrows to $2, giving me a skewed stance that aligns with my bearish outlook. It’s a tweak to the traditional butterfly to nudge the profit potential in the direction I’m speculating.

Delta Dynamics

With any options strategy, understanding and managing delta—the sensitivity of an option’s price to changes in the underlying stock’s price—is crucial. By structurally altering my broken wing butterfly, I can directly influence the delta, giving me an added edge directional move I expect. Let’s imagine I believe the stock I’m looking at will dip; I’d adapt my strategy to favor that direction.

Here’s how it works with deltas: I arrange my spread so that if the stock price plummets beyond my lowest strike price, the trade still retains value. Structurally, this looks like a $5 wide long put spread (from $150 to $145) paired with a tighter $2 wide short put spread (from $145 to $143). This asymmetry means at expiration, if the stock has descended past $143, my position’s worth won’t shrink to nil as it might with a traditional butterfly. So, if the stock ends up at $140, instead of my trade being worth nothing, it would still hold a value of $3 because of the wider long spread cushioning the drop past the shortest wing.

EXAMINING THE BEARISH BROKEN WING BUTTERFLY STRATEGY IN QCOM

When setting up a trade set up at Prosper Trading Academy, it’s useful to examine strategies that let me capitalize on my market outlook but more importantly, maximize my risk to reward. Let’s go back to my broken wing butterfly example. My usual go-to, the symmetrical butterfly spread, wasn’t as fitting for my directional bias this time around.

I’ve picked QCOM as my case study, given my bearish stance on the stock. As of the April 14th expiration, QCOM was priced at $152.50. The expected move derived from the options premiums suggested an $8 shift. But remember, this figure is direction-agnostic; it merely indicates the magnitude of the potential price change.

Guided by my bearish bias, I’m targeting a move down to $144.50 by expiration. Since that’s an unlikely strike to find, I rounded to the closest available option, selecting $145 as my target. Now, had I employed a standard bearish butterfly, I’d align my puts at $150, $145, and $140, each equidistant and creating a well-balanced risk-reward profile.

But here’s where the broken wing variant comes to play:

• Initially, my spread structure might resemble the familiar setup with the $150 and $145 puts. However, instead of placing the lower strike put at $140, I’d select $143 – emphasizing a distinct asymmetry.

Now, for the numbers:

• The long put spread ($150 – $145) is $5 wide.
• Conversely, the short put spread ($145 – $143) measures just $2 wide, revealing the ‘broken’ aspect.

This widening on one side injects additional directional bias into my position, as it alters the deltas involved.

How does that benefit me?

• At or above $150, the whole thing’s worthless because all options expire out of the money.
• At $147, the long spread is worth $3, with the short side contributing nothing. Hence, my position is valued at $3.
• Optimal profitability still coincides with the stock hitting the short strike of $145. Here, I see $5 – the maximum potential payout.
• Should QCOM decline further, to say, $144, the long spread is worth $5, and the short spread is now valued at $1, leaving my position at $4.
• At $143, the position drops to $3. That’s my ‘magic number’, as the imbalance in spread widths guarantees this minimum value.

What’s the conclusion?

• Even if QCOM plunges below my lowest strike, unlike a classic butterfly spread that becomes worthless, the broken wing butterfly ensures a retained value – never dipping below $3 in my example.

If QCOM tanks to $140, or even to $100, hilariously far from my initial guess – I still pocket $3.

By accepting a slightly higher upfront cost compared to a regular butterfly, the broken wing butterfly guarantees a floor value. Thus aligning neatly with my bearish anticipation, yet still offering a cushion should QCOM exceed my expectations and slide further south.

Butterfly vs Broken Wing Butterfly: A Comparative Glance

In the alternative scenario of a broken wing butterfly, I’d place the long put spread wider than the short one, say $150-$145 put spread paired with a shorter $145-$143 put spread. This tweaks the symmetry and leaves me with an uneven risk distribution, a feature that can still reward me even if the stock overshoots my lowest strike.

My objective remains the same—to see the asset hit my short strike for maximum profit. Yet, if the stock plunges past the lowest strike, something intriguing happens. Instead of my position turning worthless, as with a regular butterfly, the broken wing setup retains value. At $143, the extended spread guarantees the value never drops below $3, a stark contrast to the standard butterfly’s potential to hit zero.

So, by choosing a broken wing butterfly, I’m betting a bit more coin with the comfort of knowing that even a steeper than expected price dip won’t leave me empty-handed, as the value stabilizes and doesn’t drop below a certain point. This slight cost increase is the price I pay for that added cushion and a more unidirectional advantage in my trade.

EXAMINING PROFITS AND LOSSES IN OPTION SPREADS

When putting on a spread like a broken wing butterfly, it’s crucial to know how profits and losses can play out. Let’s say I’m looking at a bearish setup and choose Qualcomm (QCOM) as my target. I assume a bearish stance, with QCOM trading around $152.50. By calculating the expected move based on the straddle price, which is about $8, I can set my bearish target around $144.50. Since there’s no half strike, I’d round to the nearest, either $144 or $145. For simplicity, I’ll work with $145.

In a typical butterfly spread, I might set up $150/$145/$140 strikes, with both my long and short put spreads evenly $5 wide. However, in a broken wing butterfly, I alter the spread to adjust for direction. Instead of a symmetrical spread, I could set it to $150/$145 on the long side and $143 on the short, which is uneven and gives the position an additional direction, or “delta.”

Here’s a breakdown using the broken wing butterfly:

• Initial Spread:
  • Long side: $150/$145 put spread (5 points wide)
  • Short side: $145/$143 put spread (2 points wide)
• Cost Impact:
  • The cost might increase from 70 cents to around $1 to $1.05 to set up the skewed spread.

At Expiry Scenarios:

• Above $150:
  • The spread expires worthless as all options would be out of the money.
• At $147:
  • Long spread would be worth $3 (5 point spread with 2 points ITM)
  • Short spread worthless
  • Total value of position: $3
• At $145:
  • Maximum potential value at $5

Beyond the Short Strike:

• At $144:
  • Long spread is worth $5
  • Short spread is worth $2 (2 points ITM)
  • Net position value: $4
• At $143:
  • Long spread is worth $7
  • Short spread is worth $4 (2 options of $2 each)
  • Position value stabilizes at $3

Should the stock plummet past the lowest strike, my broken wing spread would still carry a value, never dipping below $3. This is in contrast to the regular butterfly spread where the value would collapse to zero past the end strike.

Setting up a broken wing butterfly means I pay slightly more upfront for the advantage of retaining value on a significant move past the last strike. My aim is to have the stock gravitate towards my short strike, but if it continues past that point, my position still remains profitable.

CONCLUSION

The broken wing butterfly spread can be a fantastic strategy to use to maximize your risk to reward on an option trade. It’s always important to compare different option strategies when determining how to best play a move in a particular stock.

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Originally Posted December 19, 2023 – Broken Wing Butterfly Spreads – Everything You Need To Know