Hey everyone.
This is Kirk, here again at optionalpha.com.
And in today's video, I want to show you guys exactly how we turned a broken wing butterfly
into a regular butterfly, with no downside loss, total upside profit potential.
So at this point, we have a regular butterfly on that we had hedged into via a broken wing
butterfly.
And now, we have a position that will not lose money, no matter where the stock trades,
and actually should make us a pretty decent profit regardless.
So, I'm going to walk through that step by step.
And again, I want to start with the broken wing butterfly, how we created that position
in the first place, and then walk you through how we got to the regular butterfly, so that
you guys understand that logic and how we made those trades.
So, right here is just a very simple profit and loss diagram for a broken wing butterfly.
So again, I've gone over this a couple of times in the other videos, but just to recap
what you do on a broken wing butterfly.
And in this instance, it's a put broken wing butterfly, so we're just trading puts.
But you'd buy one of the D strike puts and that creates this profit loss, until you get
to point C or C strike where you would sell twice as many of the options that you bought
here at D. And you can see that's pretty evenly spaced, so it's just probably the next strike
price down.
After that, this is where the broken wing comes into play.
You actually skip over strike B. So in this case, we go all the way down here to strike
A and we'd buy another put down here at strike A, and this creates this long end of the profit
loss diagram or this broken wing, and that's because you're skipping over a strike.
So, if these strikes are $5 wide, you'd make this difference here $10.
If C and D are $1 wide, you'd make this difference here $2 in strike price, okay?
So, that's a very simple explanation of what the broken wing butterfly is.
Now, let's look at the trade that I initially put on in the trading alerts for members.
Again, this only went out to members, so you can't get these unless you subscribe at optionalpha.com.
But the initial trading alert was opening and we bought two, such as how many butterflies
we bought, EEM December 13, 2013 options.
But here's where the strike prices come into play.
So, we bought the 42 and we sold the 41's, and then you can see, we skipped over the
40's and we went all the way down to the 39's and bought the 39's.
So the 42's, the 41's, and the 39's.
This altogether, created a credit of $.12 per butterfly.
So not a huge credit, but what that did is allowed us to at least lock in a profit should
EEM trade anywhere above, say basically 40 at expiration.
But here's what happened.
EEM started trading higher, so what we did is we actually bought back this embedded vertical
that was missing.
So, remember I keep talking about this missing strike price that you skip over with a butterfly.
And this is how you turn that broken wing butterfly into just a regular butterfly with
total upside potential.
So down here, you can see what alert went out to members just the other day, and that
was to hedge this trade by buying the vertical in EEM.
Again, the same December 2013 options.
And here's the difference.
In this instance, we bought back the embedded vertical which was the 40 (that missing strike
price) and the 39.
So, we closed out the 39 and established a new strike at 40.
This altogether, total, cost us $.11 per vertical.
So, you can see we originally took in $.12 in credit and it cost us $.11 in debit to
actually hedge this trade, and so, we still have $1 left over at the very least.
But you'll see here shortly on our profit loss diagram that we actually have a very
good position where we have no downside potential in this butterfly.
It's a total 100% upside potential for EEM.
So, let's go to the actual chart here.
This is a look at my actual trading platform.
And I've thrown in the simulated trade here that we'd made that hedge trade just to show
you guys what we did as far as the original trades.
So, this is a profit and loss of the original trade that we made.
And I'll go through it.
So again, you can see here we bought the 42's, and that was here.
That kind of pins this breakeven point all the way out here at past 42.
We bought the 42 puts, then we came up to the 41's, sold twice as many 41's, we skipped
all the way over that 40 strike and went all the way down here to 39 and bought 39 puts.
So, this is the original profit and loss diagram that we had on this broken wing butterfly.
Again, you can see, we leave that upside potential here because we took in a credit on the trade.
But what we did is when we hedge the trade, we got rid of these 39's.
So, these 39's that are down here that we originally bought, we closed out that order
and we opened a new order right down here at 40.
And what this does is this creates a profit loss diagram that looks like your regular
butterfly.
So again, I'm going to remove this trade, so I can show you the original or now the
new trade that we have on right now.
So, this is the result the new butterfly that we have on.
We still have the 42 strikes right here.
We are still short.
The 41's twice as many as the 42's.
And then you can see here we now have moved our further strike from the 39's to the 40's.
This creates this very natural, normal butterfly graph that you're looking at.
But if you look here on our profit loss on the downside, there is no possible area where
we actually lose money on this trade, so it's completely free, and that's because we bought
back that embedded vertical for the same price or less as the total credit that we took in.
So now, this is a butterfly that only cost us about $1 in credit.
So, we have $1 in credit built-in, but no matter where the stock trades, we're actually
going to make money on this trade regardless of where EEM trades.
So, our ideal position obviously, would be to hold it until it gets very close to this
41 strike, and that's where we start making a lot more of our money in this butterfly.
So, we're going to hold this trade pretty close to expiration, unless EEM starts trading
very close to 41.
And then at that point, we'll close it out for a nice little profit.
So, that's what the broken wing butterfly looks like.
And now, what the broken wing has turned into is just a regular butterfly with no downside
potential and total upside profit.
So hopefully, that was really easy to follow and understand.
As always, if you have any questions or comments, please add them right below to the video.
And happy trading!