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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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Options Trading: Sell the Meat and Buy the Wings

Mark,


I heard about a saying in the options world 'sell the meat, buy the
wings', which I believe to be short CTM options and long 1 1/2 as many options that are many strikes further away but in same expiration
month.

I ran different positions on the risk graph to reflect what it
might look like and found the Greeks to be similar to that of an Iron condor, but
with a better pay off and possibility of performing well in a big move
event.


Would you be so kind as to respond in a blog post or a reply as to the
pitfalls of this positions and how best to manage?

Joe

***

Hello Joe,

Your interpretation of 'sell the meat; buy the wings' is not the one commonly used.  It's a flexible term and describes any butterfly, iron condor or credit spread.

The options bought may be several strikes removed, and you certainly may buy extras, but neither is necessary.


Any option whose strike price is farther OTM, even when it's the next nearest strike, is sufficient.


Joe, there is one portion of your comment/question that is crucial to this discussion, and I want to be certain that you understand the situation.

Any time you own extra options, the 'payoff' is going to look better on the risk graphs. Thus, be certain you get all the relevant information from those graphs. Sure the payoff is better today and tomorrow.  Joe: Have you considered how this position looks as time passes?  

Let's look at a position that fits your description.  For simplicity, let's examine just one side of the iron condor, or a simple credit spread.

Example. 

INDX is trading @860; Expiration is 7 weeks from today.

Sell 10 INDX 890 calls

Compare:

Buy 10 INDX 900 calls (figure 1, BLUE)

vs. Buy 15 INDX 940 calls (figure 1, RED)

 

One.1

figure 1


The thin lines show the profit and loss picture as of today, and the solid lines represent the value of the position when expiration arrives.  It is true that the back spread does better than selling the call spread if there is an immediate rally to 980.  But have you considered how this trade looks as time passes?


Here's the graph, just three weeks later.

 

One.2
figure 2

That thin red line's not looking so good anymore.  Again, this is a personal view, and from my perspective I would never open this type of trade.  A rally hurts, the passage of even a small amount of time hurts, an IV decrease hurts – and that's extremely likely if you get the desired rally.

Joe, I suppose you could say that the red line shows a 'better' risk graph becasue there's the chance for a big profit if the index moves higher by 200 points (23%) or more – in the next seven weeks.

But, from my perspective, this risk graph is far worse and the trade is far more risky.  The solid line represents the profit/loss at expiration.  The potential loss of $50k would talk me out of this trade.  Let me ask: What is it that you like about this?  Or did I pick a poor example?

To most of the options world, 'sell the meat and buy the wings' means to sell the more expensive options and buy the less expensive options.  Yes, you can buy extra options, but there is no need to make them so far OTM.

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