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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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Ratio spreads. Part I

There are several commonly used option strategies that never get mentioned at Options for Rookies.  I have my reasons for ignoring those strategies.  However, because this is an options education blog, it's worthwhile to describe some of these methods, explain the pros and cons of using them, and each reader can judge whether such strategies are appropriate.

One such strategy is the ratio spread.  It is sometimes referred to as a 'front spread' because it is the direct opposite of a back spread.

Ratio Spread

This term can have a broad or more narrow definition.  It's the narrow definition that is used most frequently:

Broad definition: A ratio spread is any option strategy in which the trader sells more options than he/she buys. 

The more limiting definition includes: Similar to a vertical spread, all options are on the same underlying stock or index and have the same expiration date.  Only the strike price differs.  The options sold always have a smaller delta than the options bought.

Many times the ratio spread is initiated as a delta neutral position.  However, when you are trading with a market bias, you may prefer to select specific options and a specific ratio to suit your market expectations (more on that tomorrow).  Let's look at examples.

Note:  The following are randomly chosen spreads and are not recommendations.  I will not be trading any of these examples for my own account.

Example.  Ratio call spread

Buy 1 AAPL Jan 330 Call
Sell 2 AAPL Jan 350 Calls

This is referred to as a "1 X 2 call spread,"  with 'X' being used to represent the word 'by.'

As I write this (Nov 18, after the market close), AAPL is 308.43 and the estimated execution prices for this trade are $6.60 and $2.70.  The trader pays $6.60 for the call purchased and collects $2.70 for each call ($5.40 total) sold.  Thus, the cost to buy this position is $1.20.  As with any other options trade, that $1.20 is per share and the true cost is $120.

The total description of this trade is: "The trader bought the Jan APPL 330/350 1 x 2 call ratio spread at a net debit of $1.20"

IMPORTANT NOTE: If you describe this trade verbally, especially when entering the order through your broker, you MUST use the lowest common denominator for the ratio. 

In other words, if you enter this trade 20 x 40, the terminology is: "Buy 20 1 x 2 spreads at a net debit of one dollar and twenty cents for each 1 by 2."   Never, tell the broker that this is a total debit of $2,400 ($120 * 20).

Example.  Ratio put spread

Buy 2 AAPL Jan 270 Puts @ $7.10
Sell 3 AAPL Jan 260 Puts @ $5.20

This is a "Jan AAPL 270/260 2 by 3 put ratio spread at a net credit of $1.40"
This position is initiated with the trader collecting a cash credit of $140.

What's the Problem?

There is nothing truly 'wrong with spreads of this type, and experienced traders use them as part of their trading arsenal.  The main reason that I don't discuss ratio spreads is because they are positions in which you would be 'net short' options.  These are referred to as 'naked' shorts.

Many brokerage firms do not allow any of their customers to own positions with naked call options.  Others allow experienced traders to sell naked puts and calls.  Thus, some of you would be limited in your ability to trade this type of position, depending on the whim of your broker.

Risk Management.  That's the problem.  The major focus of this blog is to help rookie option traders learn to trade options successfully.  To do that, it's very important to recognize, and control, risk – in the form of 'how much money can I lose on this trade in the worst case scenario?'  Naked short positions make it impossible to gauge a worst case (for calls) and it bcomes difficult to keep a handle on current risk.

When short naked options, the loss is theoretically unlimited for calls and the value of the strike price (x 100) for puts.  In reality those extremes do not occur.  Yet, gigantic losses are possible.  That's why I never suggest that rookie option traders ever hold positions that are naked short any call options.  I make one exception for holding naked put options: If you want to accumulate stock positions for your portfolio, one acceptable method for attempting to do that is to sell naked put options.

The combination of

  • Horrific results are unlikely but possible
  • In general, brokers do not allow inexperienced traders to sell naked options
  • I believe that it takes a good deal of experience before considering selling naked options
  • I never sell them myself (simply because margin requirements are too high)

puts me on record for not recommending these trades to my audience of rookie traders.  Many experienced traders can handle  these spreads because they have seen what the market can do.  I assume that any trader who has been in the game long enough to have gained significant experience, survived because he/she already understands the importance of manageing risk. [That's my way of saying that traders who ignore risk will not survive very long]

Broken Wing Butterfly (BWB)

One other possibility for limiting risk and making the ratio spread a viable alternative is to buy one extra call or put option for each option sold.  In other words, there are no longer any naked shorts.  That option

  • Is farther OTM than the short options
  • Provides ultimate protection by 
    • Limiting losses
    • Reducing margin requirments
    • Creating a position that all brokers will accept

This new position is known as a butterfly spread – if the options owned are equally distant from the options sold:

Butterfly example:

Buy one AAPL Jan 330 call
Sell two AAPL Jan 350 calls
Buy one AAPL Jan 370 call

In most scenarios, the option bought is farther OTM and the distances are unequal. That new position is called a broken wing butterfly and is the position typically adopted by more conservative traders who want to trade ratio spreads.

Broken Wing Butterfly (BWB) Example:

Buy one AAPL 380 (or higher strike) call – instead of buying the Jan 370 call.

I'll have more to say about BWBs later in this series.

Next time I'll discuss the risk profile for ratio spreads and how your market outlook plays a role in choosing strike prices when trading ratio spreads.

to be continued

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