Call Broken Wing Butterfly Spread

Call Broken Wing Butterfly Spread Risk Graph
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Call Broken Wing Butterfly Spread - Introduction
The Call Broken Wing Butterfly Spread, also known as the Broken Wing Call Butterfly Spread or Skip Strike Butterfly Spread, is a variant of the Butterfly Spread options trading strategy. Similar to the Butterfly Spread, it is a neutral options strategy but unlike the butterfly spread, it transfers all the risk of loss when the stock breaks downwards onto the upwards side. This means that the Call Broken Wing Butterfly Spread does not lose money when the stock ditches downwards but will lose more money than a Butterfly Spread if the stock rallies. This is particularly useful when the stock is expected to either stay stagnant or break downwards.

Yes, Broken Wing Butterfly Spreads are butterfly spreads that transfer the risk of loss on one leg onto the other. This creates an assymetric risk graph that favors the stock moving in a certain direction. The Call Broken Wing Butterfly Spread protects against the stock breaking downwards while the Put Broken Wing Butterfly Spread protects against the stock breaking upwards. Learn about Broken Wing Butterfly Spreads first.

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Main Difference Between Call Broken Wing Butterfly Spread and Butterfly Spread
The main difference between the call broken wing butterfly spread and the butterfly spread is that the call broken wing butterfly spread transfers the potential downside losses onto the upside. The Call Broken Wing Butterfly Spread achieves this simply by buying further out of the money call options instead of call options at the same distance from the middle strike price as the in the money call options.

In a regular butterfly spread options trading strategy, both in the money options and out of the money options are bought at an equidistance from the middle strike price. This creates a symmetrical risk graph with equal risk of loss on both upside and downside.

By moving the out of the money call options further away from the middle strike price than the in the money call options, the Broken Wing Butterfly Spread reduces the debit of the position to the extend that the position is either a zero cost position or a credit spread. The result of such an adjustment is that if the stock goes downwards, the position gains the net credit if it is a credit spread or simply makes no loss if the position is a zero cost one.

Example : Assuming QQQQ trading at $43.57.

Regular Butterfly Spread

Buy To Open 1 contract of Jan $42 Call at $2.38
Buy To Open 1 contract of Jan $44 Call at $1.06
Sell To Open 2 contracts of Jan $43 Call at $1.63.

Net Debit = (($2.38 + $1.06) - ($1.63 + $1.63)) x 100 = (3.44 - 3.26) x 100 = $18.00 per position

Call Broken Wing Butterfly Spread

Buy To Open 1 contract of Jan $42 Call at $2.38
Buy To Open 1 contract of Jan $45 Call at $0.40
Sell To Open 2 contracts of Jan $43 Call at $1.63.

Net Credit = (($2.38 + $0.40) - ($1.63 + $1.63)) x 100 = (2.78 - 3.26) x 100 = $48.00 per position

The Call Broken Wing Butterfly Spread options trading strategy is so named because one "wing" is shorter than the other.

When To Use Call Broken Wing Butterfly Spread?
One should use a Call Broken Wing Butterfly Spread when one expects the price of the underlying asset to change very little over the life of the option contracts and speculates that even if the underlying asset should stage a breakout, the breakout will most likely be downwards.

How To Use Call Broken Wing Butterfly Spread?
There are 3 option trades to establish for this strategy : 1. Buy To Open X number of In The Money Call Options. 2. Buy To Open X number of Out Of The Money Call Options with a further strike difference than the in the money call options bought. 3. Sell To Open 2X number of At The Money Call Options.

The choice of which strike price to buy the In The Money leg (trade 1) depends on the range within which the underlying stock is expected to trade . If the underlying stock is volatile and could move by a larger degree, you will need to buy a deeper in the money call option. However, there will come a point where the in the money call option is more expensive than the net credit collected, thereby rendering the Call Broken Wing Butterfly Spread ineffective. This is why the nearest In The Money option is usually the one chosen.

The role of the out of the money call options is not only to reduce the margin requirement of the Call Broken Wing Butterfly Spread but also to set the point beyond which the position will stop losing money if the stock rallied. Generally, it has to be far enough out of the money to allow the Call Broken Wing Butterfly Spread to result in a net credit or net zero cost but not so far as to result in the margin requirement or the maximum loss potential being too high. As such the Call Broken Wing Butterfly Spread usually skips only one strike price out as you see in the examples here.

Call Broken Wing Butterfly Spread Example

Assuming QQQQ trading at $43.57.

Buy To Open 1 contract of Jan $42 Call at $2.38
Buy To Open 1 contract of Jan $45 Call at $0.40
Sell To Open 2 contracts of Jan $43 Call at $1.63.

Net Credit = (($1.63 - $0.40) + ($1.63 - $2.38)) x 100 = $48.00 per position

The profitability of a call broken wing butterfly spread can be enhanced or better guaranteed by legging into the position properly.

Profit Potential of Call Broken Wing Butterfly Spread :
Call Broken Wing Butterfly spreads achieve their maximum profit potential at expiration if the price of the underlying asset is equal to the middle strike price.

From the above example : Assuming QQQQ close at $43 at expiration. You will profit from the value of the 2 at the money short call options and you will lose the value of the long out of the money call option and the extrinsic value of the in the money call option.

Profit Calculation of Call Broken Wing Butterfly Spread:
Maximum Profit = [(Middle Strike - Lower Strike) + Net Credit] x 100

Maximum Loss = (higher strike - skipped strike - net credit) x 100

From the above example :

Maximum Profit = [(43 - 42) + 0.48] x 100 = 1.48 x 100 = $148 per position

Maximum Loss = (45 - 44 - 0.48) x 100 = 0.52 x 100 = $52 per position

Risk / Reward of Call Broken Wing Butterfly Spread:

Upside Maximum Profit: Limited

Maximum Loss: Limited

Losing Point (Break even point) of Call Broken Wing Butterfly Spread:
A Call Broken Wing Butterfly Spread makes a loss only when the stock rallies above the losing point.

Losing point = skipped strike + net credit

From the above example :

Losing Point = $44 + $0.48 = $44.48.

Advantages Of Call Broken Wing Butterfly Spread:

Transfer downside risk totally into the upside leg.

Higher maximum profit than a regular butterfly spread.

Disadvantages Of Call Broken Wing Butterfly Spread:

Higher margin requirement than a regular Butterfly Spread.

Higher maximum loss than a regular butterfly spread.

Alternate Actions for Call Broken Wing Butterfly Spreads Before Expiration :

1. If the underlying asset has gained in price and is expected to continue rising, you could buy back the short call options and hold the long call options.

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