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Learn to execute the broken wing butterfly strategy effectively with this article, which will include setting up the broken wing butterfly options strategy with examples, its advantages and disadvantages, and how traders can get maximum benefit by incorporating this butterfly spread strategy in their trading arsenal.
Profitable Options Trading with the Broken Wing Butterfly Strategy
As we all know options trading is the only branch of trading in which traders can make money in volatile markets also; if he has the knowledge of the right strategy. One such advanced option trading strategy is the Broken wing butterfly strategy. This is a slight modification of the traditional butterfly strategy. Traders utilize this when the markets are volatile and they need to set up a low-risk high-reward position. In this article, we will learn how to set up a broken wing butterfly options strategy using an example along with its advantages and disadvantages. Also, we shall see how this butterfly spread strategy adjustments can help traders in their trading journey.
What is a Broken Wing Butterfly Strategy ?
A broken wing butterfly strategy is an advanced options trading strategy; it involves creating long and short options positions in a way to get maximum profit. This butterfly spread strategy is generally used when a trader has a directional bias and still wants to minimize the risk. By adjustments of the short and long strike prices, traders can manage the potential losses and gain high profits if the market moves as per their planned direction.
How To Set Up a Broken Wing Butterfly Options Strategy ?
To set up a broken wing butterfly strategy, traders need to select contracts having different strike prices; in a way that creates asymmetry in risk and rewards ratio. Check the stepwise process below :
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Check if the market is bearish or bullish, accordingly a bearish or bullish broken wing butterfly spread will be created.
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Identify the three different strike prices to create a butterfly spread.
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Now Buy one ITM ( in-the-money) option contract.
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Sell two ATM (at-the-money) options contract
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Buy one further OTM (out-of-the-money) option contract.
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Based on the market condition, enter into the trade and execute the trades with either a call or put options contract.
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Finally, consider hedging or exit strategies adjustment if the market moves in unexpected ways.
How the Broken Wing Butterfly Spread Works ?
The broken wing butterfly spread is a modified version of the broken wing butterfly strategy. In this options strategy, one strike price is further away which is the key to making a profit.
Let us see how broken wing butterfly spread works and what potential outcomes it offers :
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If the price of the underlying asset stays near the middle strike price at the time of expiry, maximum profit is generated.
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If the underlying asset's price moves upwards, the trader still gets profit, but if it is in a favourable direction and within a specific range.
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If the underlying assets price moves beyond the long position, then also the loss is limited, due to the farthest strike price selected.
This outcome can be better understood by the broken wing butterfly options strategy example, check below
Understanding Broken Wing Butterfly Option Strategy with Example
Example of a Broken Wing Butterfly Strategy in a Bullish Market Scenario :
Suppose, an asset is trading at ₹100 and he believes that price will rise but not more than ₹110. In this scenario, he will set up a butterfly spread or broken wing butterfly strategy adjustments as follows :
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Buy one call at ₹95 by paying ₹7 as premium
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Sell 2 calls at ₹100 and receive ₹10 (5 from each)
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Buy 1 call at ₹110 by paying premium of ₹2
Total Net cost = 7-10+2= ₹1
Potential Outcomes of broken wing butterfly options strategy
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If the asset expires at ₹100, max profit is achieved as it expired worthless.
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If the asset's price falls below ₹95, no significant loss is seen as the downside risk is covered.
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In case the asset closes at or above ₹110, a small loss may occur or the trader may reach a break even point.
Benefits a Trader Gets By Using Broken Wing Butterfly Options Trading Strategy
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This strategy has a limited risk and higher profit potential.
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Traders can adjust the risk and reward ratio by adjusting one wing of the strategy, as per market condition.
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Low entry cost compared to butterfly strategy.
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The benefit of earning net credit, in case the price does not move
Pros and Cons of Broken Wing Butterfly Strategy
Pros :
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The risk is predefined
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Traders can define their profit zone as per the market scenario.
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Chances for zero-cost or low-cost entry or sometimes net credit.
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The impact of market volatility is low on this broken wing butterfly options strategy
Cons :
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Some may find it difficult to execute butterfly spread because of more legs
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Compared to simple options trading, executing this broken wing butterfly strategy needs additional margin
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Although it has limited risk, it still needs to be monitored for making any necessary changes, as the market is uncertain.
Conclusion
The broken wing butterfly strategy is one of the best, when traders want to have a defined approach of risk and reward. This is majorly used when traders are sure about directional movement, but still want protection. Initially broken wing butterfly options strategy adjustments may feel complex to execute but with proper market understanding and risk management techniques, traders can make informed and profitable decisions in their trading journey.