Broken Wing Butterfly Option

A Broken Wing Butterfly is a variation of the standard butterfly options strategy. It is designed to provide a larger profit potential or reduce the cost of the trade by shifting one of the wings further away from the center strike price. This adjustment creates an unbalanced position, hence the name “broken wing.”

How a Broken Wing Butterfly Works

A standard butterfly spread involves three strikes:

• Buying one in-the-money (ITM) option
• Selling two at-the-money (ATM) options
• Buying one out-of-the-money (OTM) option

In a Broken Wing Butterfly, the structure is adjusted by moving the further OTM strike (or sometimes the ITM strike) further away from the center strike. This adjustment can be done with either call options or put options.

Example: Broken Wing Butterfly with Calls

Let’s say a stock is currently trading at $100. Here’s how you might set up a Broken Wing Butterfly with calls:

• Buy one call option with a strike price of $95 (ITM)
• Sell two call options with a strike price of $100 (ATM)
• Buy one call option with a strike price of $110 (instead of $105, OTM)

This setup shifts the risk-reward profile of the trade. The broken wing adjustment often results in a net credit or a lower net debit compared to a standard butterfly spread.

Advantages and Disadvantages

Advantages:

1. Reduced Cost or Net Credit: By adjusting the strike prices, you can often set up the Broken Wing Butterfly for a smaller net debit or even a net credit, reducing the cost of the trade.
2. Profit Potential: This strategy can increase the profit potential if the underlying asset moves towards the OTM strike price.
3. Risk Management: The Broken Wing Butterfly can reduce risk on one side of the trade, providing a more favorable risk-reward ratio.

Disadvantages:

1. Complexity: The strategy is more complex than standard options trades and requires careful management.
2. Limited Profit Zone: Like all butterfly spreads, the profit zone is relatively narrow. Significant movement in the underlying asset away from the targeted range can result in losses.
3. Higher Commissions: More legs in the trade can lead to higher commission costs.

Risk Profile

The risk profile of a Broken Wing Butterfly is asymmetric due to the adjusted strike prices. The strategy has a higher maximum profit potential than a standard butterfly if the underlying asset price ends up near the middle strike at expiration. However, the risk on one side is increased if the asset price moves significantly away from the desired range.

When to Use a Broken Wing Butterfly

This strategy is typically used when:

1. Market Neutral to Slightly Bullish/Bearish Outlook: You expect the underlying asset to stay within a certain range or move slightly in a particular direction.
2. Implied Volatility Considerations: When implied volatility is expected to decrease, this strategy can benefit due to its structure.

Conclusion

The Broken Wing Butterfly is an advanced options strategy that offers traders the potential for reduced costs and increased profit potential by adjusting the strike prices of a traditional butterfly spread. It is particularly useful in markets where the trader expects limited movement but wants to optimize risk and reward. As with any complex strategy, it requires a thorough understanding and careful monitoring to manage effectively.