The broken wing butterfly and the butterfly spread are two different types of option trading strategies that involve trading four option contracts with the same expiration date, but with three different strike prices.
These strategies can be profitable for investors, but also contain risk. This article will explain the broken wing butterfly and butterfly spread strategies so investors are better prepared to avoid those risks.
In order to understand the broken wing butterfly, it is best to first understand the butterfly spread. In the butterfly spread, the investor sells two option contracts at the middle strike price, while buying an option contract at a lower strike price and buying another option contract at a higher strike price. The options that are bought at the lower and higher strike prices should be equidistant from the middle strike price; these are known as the wing options.
Call or put options can be used in the butterfly spread. This strategy is used when an investor believes that the price of the underlying security will not deviate much from the current market price.
For example, assume an underlying security is priced at $50. An investor sells two call options with a strike price of $50. Then, the investor buys two call options with one having a strike price of $45 and the other having a strike price of $55.
The investor will realize his maximize profit from this strategy if the underlying security is priced at $50 by the options’ expiration date. If the underlying is priced below $45 or above $55 at expiration, then he will realize his maximize loss, which would be the cost of buying the wing options plus the proceeds of selling the two middle strike options.
If the underlying security is priced between $45 and $55 at expiration, then it could be a loss or a profit depending on the premiums.
Now let’s look at the broken wing butterfly strategy, which is similar to the previous strategy, but has a slight variance.
The broken wing butterfly strategy consists of the investor selling two options at the middle strike price. At the same time, he buys an option below the middle strike price, then skips a strike level to buy another option above the middle strike price.
The options that are bought below and above the middle strike price are not equidistant here. This is the key difference between the broken wing butterfly and the butterfly spread.
By skipping a strike level, this strategy becomes cheaper than the butterfly spread strategy, but also assumes more risk.
Let’s look at an example of this scenario taking place.
Assume a stock is trading at $50. An investor sells two call options with a strike price of $51. Then, the investor buys a call option with a strike price of $46 and another call option with a strike price of $66. One option strike is $5 away from the middle strike, whereas the other option strike is $15 away from the middle strike. The option with the strike that is farther away is called the “broken” side, hence the broken wing butterfly.
In this scenario, the best result would be if the stock increases, but not above $51. Let’s assume the stock is at $50.50 at expiration. The two call options sold with a strike of $51 would expire worthless and the investor will profit from the premiums of those options. The call option with a strike price of $66 will also expire worthless. The investor will take a loss for that premium.
For the call option with a strike price of $45, the investor will exercise his right on that option.
In total, the investor will profit from exercising his right on the $45 strike call option plus the two premiums paid to him, minus the one premium he paid. The investor walks away with a profit because the stock didn’t make any significant moves.
Hopefully, these examples make it clear as to what these strategies entail. The broken wing butterfly and butterfly spread are both great strategies to use when an investor believes that the underlying stock is going to remain relatively constant.