Ratio Spreads: Part IV. Broken Wing Butterfly

The first three posts in this series on ratio spreads (Part I, Part II, Part III) were published recently.

The broken wing butterfly spread (BWB) is a frequently used strategy for more experienced players.  Today I'll introduce that option strategy to readers of Options for Rookies.

In general, any butterfly spread is used when the trader wants to forecast a specific price range for any underlying.  It's also created as an adjustment for existing positions (as a risk management play to limit losses or lock in profits).

In the scenario under discussion (ratio spreads) the BWB is constructed to limit losses, always a good idea when trading options.  Buying options that are relatively far OTM is not done to 'take a shot' at a gigantic market move.  Instead the trade is made to convert a position that is already short naked calls or puts (a ratio spread) into a position that is no longer short any options.  In fact, You can always buy an extra contract or two to provide an unlikely, but nice profit when the market makes an unexpected large move.  If this concept is not obvious, that's not a problem.  Use your broker's graphic software to examine the risk picture. Do not forget to look ahead and examine risk one day prior to expiration.

The BWB differs from a traditional butterfly spread as follows:

Butterfly spread: A trading strategy consisting of the sale of two options, along with the purchase of one option with a higher strike price, and one option with a lower strike price. Necessary conditions:  All options are of the same type (calls or puts); the options owned are equidistant from the options sold, all options expire on the same date

Broken wing butterfly (BWB): Same as above, except that the options bought must NOT be equidistant from the options sold.

Although these positions frequently stand on their own, they can be traded by conservative investors who would like to trade ratio spreads, but who refuse to own positions with any naked short options.  The BWB comes to their rescue.


The ratio spread

Let's say you are bearish on the market and want to make a trade that suits your expectations.  Your guess is that the market will fall, but not too far.  With RUT (Russell 2000 Index) trading near 673, you decide to Buy 3 RUT Jan 650 puts (@ $8.20) and Sell 6 RUT Jan 630 puts (@ $5.70).  This is a 1 x 2 put ratio spread, and you collected a credit of $3.20 for each spread. [Most rookie traders think of this as collecting $960.  However, that makes the conversation awkward.  It's far easier to refer to this spread – as well as any other – in terms of its lowest common denominator. That's 1 x 2 in this example]

As discussed in talking about break-even points for ratio spreads, when the market moves too far, you may lose a significant sum.  I know that you (the person making this trade) really believe the market can move through 650 – that's why you bought the 650 puts.  You also believe it will not decline beyond 630 – and that's why you sold the 630 puts.

However, if your are correct about direction, but very wrong about magnitude, there is no reason to lose a lot of money.  This trade is naked short 3 puts, and that leaves you exposed to a gigantic loss if and when there is a big market collapse.  Why take that risk when it's unnecessary? 

If you take the more conservative approach, you can buy some Jan puts and accomplish two things

  • Limit losses
  • Allow you to maintain a cash credit for the whole trade
    • Allows you to earn a profit, even when wrong – and the market does not decline

You can buy RUT Jan 590 puts @ $3.  Or you may choose to save a bit more cash and take a bit more downside risk by buying a put with a lower strike price.

Such a trade turns your ratio spread into a broken wing butterfly spread.  You would own 'a 3-lot' of the BWB:

Long  3  RUT Jan 580 puts
Short 6  RUT Jan 630 puts
Long  3  RUT Jan 650 puts

Maximum loss occurs when RUT is below 580 at expiration, and that loss is $3,000 [per BWB] minus the credit collected when opening the position.

Why $3,000? [$9,000 total].  With RUT settling below 580:

The 650/630 put spread – and you own that one – will be worth its maximum, or $2,000.

The 580/630 put spread, which you are short – will be worth $5,000


There are two main ways to earn a good profit from this spread:

a) Expiration arrives and RUT is well under 650 but above 630.  This is the risky way to play because the Jan 630s would have a good deal of negative gamma (and lots of positive time decay) as expiration day draws near.  I don't recommend holding to the end, because this is the highest risk and highest reward play – and many traders are tempted to hold and hope.  I much prefer the next method (less reward and substantially less risk).

b) Hold the position long enough that theta works its magic and erodes the price of the options.  You hope to see the market undergo a slow decline, increasing the value of the Jan 650 puts that you own, but not far enough to offset the time decay in the Jan 630 puts.

Under those conditions, you exit the trade, collecting more cash.  The profit potential is very dependent on how much time has passed, the current price of RUT, and the implied volatility of the options.  In other words, to estimate a profit, you must use an options calculator. 

One good method for establishing a rough idea of when to exit the BWB is to make a trade plan just before or after making the initial trade.  That plan sets your (flexible) profit goals, as well as the maximum loss you araae willing to accept.  Those targets make the exit decision easier – especially for the less experienced trader who may be encountering specific situations for the first time.

When the broken wing butterfly works well, deciding when to exit requires discipline.  It's always going to be tempting to wait 'just one more day' to collect that time decay.  However, the risk of a big move exists as long as you hold the trade. 

One major warning: don't ignore risk. If RUT approaches 630 far too early for your comfort, then risk of loss mounts (in fact your trade is probably already under water).  Sure, losses are limited, but that is no reason to own a risky position.  The thought process is similar to trading any limited-loss strategy, such as the iron condor.  Prudent investors take losses – by exiting, or adjusting, the trade – to prevent the occurrence of large losses.


The BWB is a stand-alone trade that gives the trader protection against unlimited losses while providing a very good profit when that trader is correct in his/her market forecast.  This forecast involves more than direction.  In other words, it's not the best choice when very bullish or very bearish.

This post provides the general idea of what a broken wing butterfly is and how it can be used to minimize risk whenthe trader owns a ratio spread.


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7 Responses to Ratio Spreads: Part IV. Broken Wing Butterfly

  1. John R. 11/30/2010 at 7:17 AM #

    Hi Mark,
    Nice article on the BWB. Why not own both BWB, puts and calls thus always knowing one will make money as long as a credit was collected on both when opened. John

  2. Mark Wolfinger 12/01/2010 at 2:15 PM #

    John R,
    You can NEVER construct such a position. options are NEVER priced to allow such a trade to be made.
    If you reply that one can do this by taking legs, that is not the same thing. Once you have taken a profitable leg, you already made money. If you choose to reinvest the profits, per your trade, that is no longer a risk-free trade.

    • Theo Paine 05/22/2013 at 11:20 AM #

      I don’t want to speak for Mark , but I think it’s a great idea to use both, a BWB call & a BWBp with the same stock at the same time. Think of it as a BWB strangle. If the stock stays within range of both – u keep BOTH credits u received. If the stock makes a MAJOR move it could land into the sweet spot on the call or put side for even more $$ besides the 2 credits received. If it blows past the short strike of either Call or Put BWB – max loss can occur on that side. The trick is to set the short strikes for both BWBs as far OTM as possible (e.g…around 15 delta or less) – for wide B.E. range & get a decent credit at the same time to make the trade worth while. Using a BWB strangle (esp in hi vol environment) is one of my fav strategies. 🙂

      Theo, thanks for the comments. Unfortunately this page was published in Mov 2010, and very few (if any) people will find it.

      Yes, the trick is to choose strike prices that make the trade a winner. Alas, my crystal ball does not work that well. So we manage the trades as necessary. I do not accept ‘holding to expiration’ to be a wise move, but it is certainly one of the alternatives. I love ‘sweet spot’ pricing when expiration arrives but my personal comfort one does not allow me to wait that long when holding a position. Obviously each of us makes our own exit decisions.

  3. John R. 12/01/2010 at 11:27 PM #

    My statement above was perhaps not written properly to convey what was in my head. The “one” was not to be construe as “oneself” but rather one of the BWB. As in Iron Condors one side will always win at expiration but that does not make you a winner unless you manage the threaten side. So when I indicated that one will always make money, it should have read one of the BWB will make money at expiration but the other may or may not or loose so much if not manage properly that the total trade will be a loss. Hope this clear up what was intended to be conveyed. John R.

    • Theo Paine 05/22/2013 at 11:29 AM #

      John: This is “BWB Strangle” (for lack of better term) is very do-able if constructed properly – ie….the short strikes for the BWBc & BWBc are way OTM (delta 15 or less) so u would have a very wide B.E range between the 2 BWBs & a high prob that the stock will remain in that range so u can keep BOTH credits. If it makes a BIG move & lands in ‘either’ sweet spot – great! It is a balancing act – ie….setting the short strikes as far apart as possible &still earn a decent credit, for a decent return on capital if both BWB expire OTM.

      Farther OTM short strikes makes sense. There are still considerations:
      –deciding how much to pay for our higher-delta long options.
      –deciding on the strike price of our lower-delta long option. we want to save cash, but need ‘real’ protection.
      –how much cash credit do we require for the whole position.

      I think all winning trades (in this scenario) provide an adequate payday. The risk-management difficulty comes with knowing when to make an adjustment to the position. It is not ‘safe’ to just ride it out, knowing that losses are limited.

  4. Mark Wolfinger 12/02/2010 at 1:21 PM #

    John R,
    Yes John. I understand the clarification.
    The BWB position consists of buying a call spread and selling a call spread. The spread sold has higher strike prices and is wider that the spread bought.
    This position is usually opened with a small cash credit to the trader.
    And yes, proper risk management is necessary when the market moves higher (call BWB) or lower (put BWB).
    Looking at the call BWB with zero downside risk (due to the cash credit for the trade), there is only upside risk. Thus, buying puts is unnecessary.
    Once you begin to make the position less risky by spending money to buy a small number of extra calls, the cash credit is going to disappear. That may not do you any good on a big rally, unless the calls bought move into the money.
    Thus, making this trade makes it possible to lose money on a decline and still lose money on a rally.
    i believe the BWB is already a limited risk trade and that you cannot afford to buy protection too early. The best you can do is to take care of risk when the market rises too far and the call spread sold threatens to turn the trade into a loser.
    Unless I misunderstand your suggestion, there is no way to protect both the upside and downside and still have a cash credit for the trade.

  5. jpb16prav 06/28/2014 at 1:43 AM #

    Nice article. Another good broken wing is to have broken wing in ration 1buy : 3 sell : 2 buy where strike prices would be assuming nifty is at 7500. Choose 1 7700 buy : 3 sell 7900 : 2 buy 8000. You always make money if nifty goes above 7700. Also you have longer gap between buy and sell.