Butterflies: Regular and Broken

Butterflies are a fun trade if you are looking to put a little more capital into the market, and have a neutral assumption on the stock.

Normally, butterflies are set up Out-Of-The-Money so you pay a small debit for the trade, rather than collect a credit (I prefer to collect credit on most of my trades, which is why I don’t normally implement a regular butterfly).

For example, to trade a regular butterfly with IWM at $135, you would buy the $136 call and $138 call, and sell the $137 call.

The profitability of the trade lies between the 136 and 138 calls. You want the short strike to be pinned- you want the stock price to end up at $137 to make the most profit.

In a sense, a butterfly is a long call spread with a short call spread on top of it. So we want our long call spread to be ITM at expiration, and we want our short call spread to be OTM at expiration. So when we combine them, it makes sense that we want the underlying to move up because of the long call spread, but we also want it to move down because of the short call spread- so we want it to move right in the middle of the two ($137, in this case)!

BUT if we take on more risk on the short call spread (“breaking the wing”), we can turn the debit that we pay for the trade into a credit! So if you move the 138 long call to 139, you have a $2 wide short call spread. You get a greater credit from your larger short spread as compared to your debit from the long call spread, which nets you a small credit, rather than a debit!

Your profitability is now to the downside of $139- you make money if IWM goes down, stays the same, or goes up just a little bit, rather than needing it to just expire at $137. This MASSIVELY increases your probability of profit.

If IWM goes down (which would be ideal in this trade), the values of the options decrease, and become closer and closer to worthless, which nets you a larger profit. Or, IWM can go up to $137, and you can sell out of your long call spread for a credit.

So there are multiple ways to make a profit, but a broken wing butterfly is more risky to the upside. The bigger short call spread can lead to some bigger losses. BUT, in both trades, your max loss is reduced by selling the 136/137 long call spread, which increases your breakeven overall. It balances itself out, just a little bit!

You make money if the stock goes up, down, or all around (to some extent!)

Who could ask for a better trade than that?

Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: