The Butterfly vs. the Broken Wing Butterfly

By Scott Kramer, Optionetics.com
Published: November 15, 2006 12:30 PM EST

Many, many people have been asking about the difference between a butterfly spread and a broken wing butterfly. Others have also written that they understand the difference in theory but not practice. In an attempt to clarify the matter, something I am not particularly good at, I will explain the two trades similarities and differences. First, let me begin with the definitions. At first glance, the two positions will sound very similar in construction, and they are, but that is where the similarities conclude as they operate dramatically different in real-world application and execution.

Note: In the examples used below I will illustrate with SPY options going off of the closing marks from a leading broker. I do this as these tend to be between the bid-ask spread, which is about the same as the spread”s mid-point. I have found that if by being patient, you can usually get filled about half the time at the mid-point, and do not need to give up the vast amount of slippage most often associated with single options of vertical spreads. This is just a rule which is not a guarantee but does occur for those who are patient enough and experienced enough in trading to trade this way. The options being used are December puts with about 33 days until expiration.

Butterfly Spread A long butterfly spread can be thought of as the simultaneous purchase a closer to ATM vertical call/put spread and the sale of a further OTM vertical call/put spread where the two spreads share a common strike. The strike shared will be at the sale portion of each vertical spread.

An example of a butterfly would be the following:
Buy 10 contracts of the 139-138 put spread (buy 139 put and sell 138 put), and sell 10 contracts of the 138-137 put spread (sell the 138 put and buy the 137 put) for a net -$0.20 debit.

Broken Wing Butterfly [BWB] A long BWB spread can be thought of as the purchase of a smaller distance between closer to ATM strikes call/put spread and the simultaneous sale of a further OTM larger distance between strikes call/put spread. In this spread, just like the traditional butterfly, the two spreads will share a common strike almost always on the sale portion of both spreads.

An example of a BWB would be the following:
Buy 10 contracts of the 139-137 put spread (buy 139 put and sell 137 put), and sell 10 contracts of the 137-133 put spread (sell the 137 put and buy the 133 put) for a net $0.05 credit.

How Each Spread Works

Butterfly

By purchasing a closer to ATM spread, you are hoping the underlying moves in the direction of the short strike price, in this example it would be the 138 strike. With the short spread you want the underlying to close ATM or OTM, in this case it would be at the 138 strike or higher (with puts).

In our example we are long a put spread where we want the index to close at 138 or lower and short a put spread where we want the index to close at 138 or higher. The two of the spreads are worth their maximum amount simultaneously at 138.

Butterfly spreads tend to not open dramatically until just before expiration because of the very real possibility of the stock/index moving away from the center strike by expiration. The less time the index has to move away from strike, the more the spread is worth.

Typically, the most that can be lose on a butterfly spread is the amount paid for the spread. This may sound like a benefit; however, when you consider in this example the spread cost us $0.15 for a maximum profit of $0.85 ($1 maximum value – $0.15 cost), and the stock/index has to close very close to exactly 138, the debit can be very expensive.

Broken Wing Butterfly

By purchasing a closer to ATM spread you are hoping the underlying moves in the direction of the short strike price, in this example it would be the 137 strike. With the short spread you want the underlying to close ATM or OTM, in this case it would be at the 137 strike or higher (with puts).

In our example we are long a put spread where we want the index to close at 137 or lower and short a put spread where we want the index to close at 137 or higher. The two of the spreads are worth their maximum amount simultaneously at 137.

BWBs tend to open up (begin to increase in value) sooner than a traditional butterfly because the distance between the strikes is greater than the traditional butterfly, and because the furtherest OTM option purchased has less value that can be lost due to time decay.

BWB Compared to a Butterfly

On the surface a traditional butterfly may appear to be the better trade because of the limited loss of the net debit. However, because of the limited range between the strikes, the relatively expensive cost of the trade, and the fact that the trade tends to not open up until very close to expiration the BWB may be the better trade.

The BWB does have an area of loss similar to a short vertical spread because the spread sold is wider than the spread purchased; however, this is usually only a problem the last few days of expiration if you let the underlying go dramatically through the most far-out-of-the-money strike without adjusting the trade. Typically, because of how options work in real-life, the deltas and gammas associated with the closer to ATM (or further ITM) spread offer enough protection for the short spread even though it is wider and theoretically has some risk.

If the BWB is placed at the right strikes, the strikes are spread apart correctly and the correct amount of time remaining until expiration is entered into, the trade is difficult to lose money with. Couple that with entering into the trade for close-to-zero cost (compared to the butterfly) and the position is hard to beat.

Think of it this way If you buy a butterfly the spread has to close near the center strike in order to make money. When doing a butterfly using OTM puts you will need the stock to sell off just the right amount to make money. The BWB, however, can sometimes make money if the stock goes in the correct direction, stays flat and even if it goes ever so slightly in the wrong direction. That is the power of the BWB compared to a traditional butterfly, or any other spread for that matter. It is also a reason why most of the more successful floor traders I was familiar with did quite a few of these trades as their core strategy.

An example of this would be fast forwarding the clock until Monday before expiration. With the index at approximately 139, an area where if the market closed there on expiration both spreads would expire worthless, the butterfly would be trading for -$.25 (a $0.05 profit) and the BWB would be trading for approximately -$0.50 (a $0.55 profit). In other words the butterfly makes $0.05, perhaps not even enough to cover commissions, and the BWB is up $0.55 (or $550 on 10 contracts).

The trades are even more dramatic if the stock is at the center strike where the traditional butterfly would be trading for about the, believe it or not, same -$0.25 (or $0.05 profit) and the BWB would be trading for about $-0.90 (or a $0.95 profit, or $950 on 10 contracts). Even if the index fell several dollars through the center strike price 9something you don”t want on expiration week with the BWB) you would still likely be up money.

Summary

Take a moment to think about this. If the spread is OTM the week of expiration (or expiration day) both spreads may expire worthless. The BWB was put on for a small credit so you will be profitable by a smidgen, whereas the traditional butterfly was put on for a debit and will result in a loss.

If the stock is at the first buy strike with a week to go until expiration the butterfly is up (in this example using today”s prices and current volatility measurements) perhaps $0.05. The BWB, however, would be up $0.55.

If the stock is at the center strike the butterfly is still only up a smidgen because of the probability that the stock will close at the sweet spot and the furthest OTM is decaying. The BWB, however, is now trading for roughly half of its maximum value and perhaps half of the position can be taken off and the other half be played with.

If the stock is at the bottom strike roughly the same profit and loss will occur has the stock been at the top strike (using puts). Yes, if you allow the stock/index to fall through the bottom strike with puts (or go above the top strike with calls) you run the possibility of a loss if you do not adjust the position. The good news for those wanting to trade the BWB, though, is that everyday you can look at the position and determine where the area of maximum profitability is, and where you would theoretically start to lose money. With that knowledge before the fact you can trade the position accordingly.

I have to state a few things for clarity and your protection. The trade above was used for example purposes only and is not the best BWB I saw by any means. I used this as a good example, not as a good trade. Please do not trade off of this. This is not a recommendation to invest in any security or derivative. Also, though it is my opinion and favorite strategy to trade, it may not be the best strategy for you. I love this trade dearly, but if you do not understand it thoroughly I would strongly suggest staying away from it until you do learn how to trade it. Many market-maker friends I had on the floors made fortunes with minimal actual risk (compared to theoretical risk) trading these type of trades, but some novices lost fortunes mimicking them not knowing what they were doing themselves. If you like them, get to know them well and they should serve you well. If you dont understand the difference between theoretical option movement and real option movement or the strategy, then I suggest you get some more education no matter what strategy you trade.