Hey everyone.
This is Kirk, here again at optionalpha.com where we show you how to make smarter trades.
In today's video, I want to go over a call broken wing butterfly.
This broken wing butterfly spread is an advanced strategy where you take a traditional butterfly
spread that you have above the market and you skip one strike when you create this spread
to basically make it unbalanced.
You can see that’s where it gets its name, this broken wing because the right side of
the profit loss diagram on your screen has this lower wing than the left side.
It’s an unbalanced spread.
Here's exactly how you would setup this strategy.
The first thing that you’re going to do is you’re going to buy one in the money
call and you’re going to do this very close to where the stock is trading.
The next thing you’re going to do is you're going to go to the next strike up and sell
two slightly out of the money calls.
This is important that we pin these out of the money calls just above where the stock
is trading to maximize the extrinsic value that is available in those options.
Then we’re going to skip over a strike and we’re going to go out to the next strike
and buy one out of the money call and this is where this strategy gets its feature by
skipping over that strike and not making it an even or balanced butterfly.
What's the risk?
Your risk is limited to the width of the first strikes.
In most cases, we do these $1 wide less the credit that you received.
If you took in a $30 credit, then your maximum risk would be $70 in this case if the width
of the first strikes is $1.
The profit potential can vary with these strategies because of the broken wing aspect to it.
At its peak, you could make the difference in the first strikes, $1 plus the credit received.
This is if the stock closes right at the peak of this strategy which would be right at the
short strike.
Remember, you sold two of those options, so that's ideally where we want the stock to
close.
Should the stock sell off, your max profit would be the credit received should all of
the options expire worthless and out of the money and this is the reason why we like to
take in a credit on this type of trade because if the stock goes down, we have no downside
risk in our trade.
Volatility increasing will generally have a negative impact on this strategy.
Because we are selling options, we want to see implied volatility go down.
If implied volatility goes up, then it’s going to hurt our short strikes which are
very close to where the stock is trading right now.
The passage of time of Theta decay really helps this position.
Because we’re net sellers of option premium, we’re selling two of those options out of
the money.
The closer we get to expiration, the faster this profit will start to materialize.
Time decay is our friend in this case and we want to make sure that we have enough Theta
decay in these positions.
As far as breakeven points, it’s very easy to calculate with these strategies.
Basically what you do is you take the skipped strike price, so whatever strike price you
skipped over and you add to that the credit that you received if you took in a credit
and this gives you your breakeven point which will be somewhere just over where that skipped
strike price is.
Let’s go to our broker platform here on Thinkorswim.
What we’re going to do is we’re going to create one of these strategies with SPY.
SPY is currently trading just above 203 right now.
The market is about to open, but it’s currently trading about 203.
We’re going to go out to the March contracts which have about 57 days to go.
What we’re going to do is we’re going to do this on the call side.
Remember, the first thing that we do is we’re going to buy a slightly in the money option
which would be the 24 strikes.
Then what we’re going to do is we're going to sell two options that are just out of the
money.
In this case, because the stock is trading at 203.08, the out of the money options are
going to be basically the 205 or 204 options just based on where the stock is trading premarket
here.
Then what we’re going to do is skip over a strike and go out even further to buy another
option.
We’re actually going to do this trade based on where the stock closed yesterday.
Stock is trading a little bit higher this morning premarket, but we’re going to do
it based on where it closed yesterday.
What we’re going to do is just right click on the 204s and go over to buy and go down
to a butterfly.
You can see this originally creates a very even butterfly $1 wide on each end and we
get a debit, but we don't want that.
We want to skip a strike on the call side.
You’ll notice we’re just buying the 203s, we’re selling two more of the 204s and we
want to skip over the 205s and buy the 206.
We’re going to buy the 203, sell two more of the 204s, skip over 205 and buy the 206.
This does give us in fact a nice credit on this trade of about $48.
That's going to help reduce our risk to the downside.
We’ll have no downside risk in this trade.
As we go to the profit loss diagram, you can see this is what that butterfly payoff diagram
looks like.
It's very similar to what we have before and you can see that our breakeven point right
here is that skipped strike of 205 plus the credit that we took in at $.48.
We’re looking at a breakeven of around 205.50 or so and if the stock does continue to move
lower, we have no additional risk to the downside in this trade, so it's a very, very high probability
trade.
As far as risk to the downside, it protects you in case the stock does move down.
Ideally, we’d like to see the stock settle around 204, so this is why it’s just a little
bit of a directionally bearish trade because we do want the stock to head lower.
That's where we make our money on this trade.
If the stock does head higher, we end up losing about $50 on this trade.
Some of the key takeaways for these broken wing butterflies: When they’re done for
an overall credit like we’ve shown, you have no risk to the downside and that’s
really important.
I definitely believe that when you trade these types of strategies, you should definitely
look to take in a credit.
This is a huge advantage when trading broken wing butterflies and still leaves you an opportunity
to profit from pinning the stock.
We have an opportunity not only to make money if the stock goes down by taking in a credit,
but we get this opportunity to make even more money if we’re directionally right and the
stock really doesn't move that much or moves down very slightly between now and expiration.
As always, I hope you guys enjoy these videos.
If you have any comments or questions, please ask them right below in the lesson page.
Until next time, happy trading!