Trading with Broken Wing Butterflies

A butterfly spread¹ is a common strategy among option traders who anticipate a stock's price to be at or close to the butterfly's short strike prices at expiration. The butterfly spread is typically put on as a debit, meaning the trader pays a net premium to initiate the trade.

However, by making a small adjustment to a butterfly spread, it's possible for a trader to potentially turn the debit into a credit through what's called an unbalanced, or broken wing, butterfly.

Following are some examples of potential spreads. For these examples, the assumption is that the underlying stock is trading at $70, and the call option chain looks like this:

A standard butterfly spread is made up of either all calls or all puts, with three equidistant strikes on a 1x2x1 ratio (see image below).

In this example, a trader is using a butterfly spread with calls. Using the data from the option chain in the table above, the trader could buy the 75-80-85 call butterfly by buying one each of the 75 and 85 calls (the wings) at their ask prices and selling two of the 80 calls (the body) at the bid price. With the stock at $70, this butterfly would cost $0.20, plus transaction costs ($1.70 + $0.70 – (2 x $1.10).

The point of maximum profit for this butterfly spread (and the apex of the diagram above) is if the stock settles at $80 at expiration. The 75-strike call would, in theory, be worth $5, and the rest of the options would expire worthless, for a potential profit of ($5 – $0.20 initial debit x 100) $480. And the point of maximum loss? If the underlying stock is on either side of the wings, below $75 or above $85, the trader loses the initial debit, $20, plus transaction costs. Traders should consider, however, that short options can be assigned at any time up until expiration regardless of in-the-money² (ITM) amount.

As expiration approaches, options might have different risks. Depending on where the underlying stock settles on expiration day, and assuming all in-the-money short and long options are assigned and exercised, respectively, a trader might be left with different positions (see below).

Transaction costs, including exercise and assignment fees, may vary depending on the brokerage firm.

If the underlying stock is near the 80 strike as the option expires, a trader might not know if they've been assigned until after the market closes, so they must wait until the next trading day to cover their position. Additionally, exercise and assignment costs may be higher than standard commission rates. Some option traders choose to unwind such positions before expiration to potentially help reduce these risks.

A trader might decide to "break" the butterfly wing by initiating a spread at a credit instead of a debit. One approach is to choose a higher (and thus less expensive) strike for the last leg (see below). This might allow a trader to collect an initial premium, but it might also expose them to more potential risk.

Referring back to the prices in the option chain table, assume that instead of buying the 85-strike call for $0.70 as the far wing, a trader bought the 90-strike call at $0.35. It costs less and turns the trade into the 75-80-90 broken wing (or "skip-strike") butterfly, and instead of paying $0.20 for the butterfly spread, a trader could take in a credit of $0.15 (with the standard multiplier of 100, that's $15, minus transaction costs).

In theory, if the stock is below $75 at expiration, instead of losing the price paid at order entry, the trader has received a premium after transaction costs. That's why some traders might use a broken wing butterfly as a substitute for an out-of-the-money³ (OTM) vertical credit spread⁴. But, unlike credit spreads where the maximum profit potential is limited to the entry credit, broken wing butterflies retain the profit potential of the regular butterfly. With this example, if the stock settles at $80 at expiration, the maximum profit of this broken wing is potentially $5 plus the entry credit of $0.15 (or $515 with the standard multiplier), minus transaction costs.

A trader can also review the "if-then" expiration scenarios illustrated above using the 90 strike to evaluate potential setbacks after expiration.

Breaking off, or unbalancing, that wing brings a trader something they might not want—added risk. Because a trader is moving the wing further OTM, they're potentially increasing their risk. For every dollar further away the wing is moving, a trader potentially increases the risk of the trade by $1 ($100 with the multiplier). In this example, moving the highest wing from the 85-strike call to the 90 strike adds $500 of risk, for a worst-case scenario of $485, plus transaction costs ($500 – the $15 initial credit).

Additionally, a debit butterfly, with equidistant wings, often incurs no additional margin requirements. However, when a trader "breaks" a wing or skips a strike, it's considered a debit spread and a credit spread, so a trader will likely be required to post additional margin.

When evaluating the added potential risk of a broken wing butterfly, some traders set the middle strike of the broken wing at the far end of their expected range for the underlying stock. That way, it'd take a bigger-than-expected move to get the stock to a potential "danger zone." For some traders, it can make sense to close the trade early if it becomes too risky for their strategy or tolerance.

Broken wing butterflies aren't appropriate for every trader, every market, nor every level of implied volatility. But understanding the mechanics of the strategy can help a trader decide whether the strategy makes sense for them.

Because broken wing butterflies can be complicated, it might make sense to practice with a paperMoney^® account before attempting this strategy.