Broken Wing Butterfly Strategy for Trading

Broken Wing Butterfly Strategy for Trading

The Broken Wing Butterfly strategy is a powerful and versatile options strategy that allows traders to capitalize on moderate price movements in the underlying asset while managing risk effectively. This strategy is particularly appealing for those looking to take advantage of mild directional moves, but with a twist that provides a higher probability of profit (POP) than traditional strategies.

In this article, we’ll explore how the Broken Wing Butterfly (BWB) works, its benefits, and why it might be the ideal choice for certain market conditions.

What is the Broken Wing Butterfly Strategy?

The Broken Wing Butterfly is an adjustment of the standard butterfly spread. It consists of three key components:

1. Buying 1 Lower Strike Option: This is the first leg of the strategy and establishes your position in the market.
2. Selling 2 Middle Strike Options: These options generate the premium that funds the trade.
3. Buying 1 Higher Strike Option: This is the third leg, which limits the potential risk on the trade.

Unlike a standard butterfly spread, where the strike prices are equidistant, the Broken Wing Butterfly strategy involves adjusting one of the wings (either the lower or upper strike) to make it further out of the money. This adjustment creates an asymmetrical structure and, in many cases, allows for a credit entry (where you collect premium), rather than the usual debit (where you pay to enter).

How Does the Broken Wing Butterfly Work?

The core idea behind the Broken Wing Butterfly is to combine elements of both a long spread and a short spread, creating a unique and flexible position that can take advantage of mild directional movements in the market.

Let’s break it down:

• Bullish Scenario: If you anticipate a small rise in the underlying asset, you could structure a BWB with the lower strike closer to the current market price. The higher strike would be placed further away, creating a net credit and shifting the probability of profit (POP) to your favor.
• Neutral to Slightly Bullish Strategy: If you expect the asset to remain within a certain range or move slightly higher, the BWB allows you to profit from a moderate price movement in either direction.
• Higher Probability of Profit: One of the primary advantages of the Broken Wing Butterfly is that it offers a wider range of profitable outcomes compared to a traditional butterfly spread, because of the asymmetry created by the adjusted strike prices.

Advantages and Risks of the Broken Wing Butterfly

Advantages of the Broken Wing Butterfly Strategy

1. Lower Cost of Entry (Credit Entry):
   • One of the key reasons traders prefer the Broken Wing Butterfly strategy is that it often allows for a credit entry. This means you collect premium when entering the trade, rather than paying for it. The adjustment to the strike prices reduces the cost of entering the position, making it a more cost-effective strategy than a standard butterfly.
2. Higher Probability of Profit:
   • The asymmetry in the Broken Wing Butterfly increases the probability of profit (POP). Unlike traditional butterfly spreads, where the stock must move precisely to the middle strike for maximum profit, the Broken Wing Butterfly allows for more flexibility. The strategy offers a higher likelihood of being profitable if the stock price stays within a reasonable range or moves slightly in either direction.
3. Defined Risk:
   • Like other options strategies, the Broken Wing Butterfly offers defined risk. Even though the structure is asymmetrical, you know exactly what your maximum loss is, which makes it easier to manage. This defined risk, combined with the potential for credit entry, gives you more control over your trade.
4. Flexibility:
   • The Broken Wing Butterfly can be adapted to different market conditions. It works well in low to moderate volatility markets, where you expect the underlying asset to experience a slight move, rather than a large shift.

Risks of the Broken Wing Butterfly Strategy

While the Broken Wing Butterfly offers several advantages, it’s important to be aware of the potential risks:

1. Higher Potential Losses:
   • Although the net credit structure reduces the initial cost, it also means that the trade is more vulnerable to large movements in the underlying asset. If the stock price moves dramatically in either direction, the wider wing can lead to larger losses compared to a standard butterfly. This makes it a riskier strategy if the market moves sharply.
2. Limited Profit Potential:
   • While the BWB offers a higher probability of profit, the profit potential is still limited. Even though you might profit from a wider range of outcomes, your maximum profit is still capped by the distance between the strike prices.
3. Transaction Costs and Liquidity:
   • Because the Broken Wing Butterfly involves multiple legs and strike prices, transaction costs can add up. Additionally, liquidity in the options market can affect your ability to execute the strategy efficiently.

Example of the Broken Wing Butterfly

Let’s consider an example of how the Broken Wing Butterfly works in a real-world scenario:

• Stock Price: $100
• Lower Strike (Long Option): $95
• Middle Strike (Short Options): $100
• Higher Strike (Long Option): $110

In this example, you:

• Buy 1 $95 Put (Long Position)
• Sell 2 $100 Puts (Short Position)
• Buy 1 $110 Put (Long Position)

The adjustment of the $110 strike to a further distance from the $100 strike results in a net credit (you receive premium to enter the trade). This gives you a higher probability of profit as the price moves slightly toward the short strike, but you still have defined risk in case the price moves dramatically.

Maximum Profit:

The maximum profit occurs if the stock price closes at $100 at expiration, where the short puts expire worthless, and your long put retains its value.

Maximum Loss:

The maximum loss occurs if the stock price moves beyond the farthest strike ($95 or $110), where the profit from the other options is offset by the loss on the out-of-the-money options.

When to Use the Broken Wing Butterfly

The Broken Wing Butterfly works best when:

1. Moderate Price Movements are Expected: It’s ideal when you anticipate that the underlying asset will move slightly, but not drastically.
2. Low to Moderate Volatility: The strategy is suited to low-volatility environments where large price swings are not expected.
3. You Want Defined Risk with a Higher Probability of Profit: If you’re seeking to enhance your chance of success while controlling your risk, the BWB may be a great fit.

Conclusion

The Broken Wing Butterfly is a versatile options strategy that can offer traders a higher probability of profit with defined risk, particularly when a small directional move is expected. While it can be more complex than a standard butterfly spread, the credit entry and greater flexibility make it a compelling choice for traders looking for a balanced risk/reward trade. However, it’s essential to be mindful of the potential for larger losses if the market moves drastically.

As with any options strategy, it’s important to understand both the advantages and risks before deploying the Broken Wing Butterfly in your portfolio. By carefully selecting strike prices, monitoring market conditions, and managing your position effectively, this strategy can add valuable diversity to your options trading toolkit.