Alex Mendoza for
Published 2/1/2010  Magazine Subscription | Article Reprints

Print This ArticleReturn To ArticleNormal TextLarge TextShare ArticleMany option traders swear by butterfly spreads as an inexpensive way to profit from an underlying closing in a predicted range. The downside to a butterfly is the total loss of capital when the stock or future closes outside the parameters that were set up by the chosen strike prices. We coined the “broken wing butterfly” variation as a powerful alternative to the butterfly with the goal of initiating the trade for zero cost. No more putting on put butterfly spreads only to see the underlying run higher causing a total loss of the debit premium, as it expires worthless.

A butterfly spread can be thought of as the simultaneous purchase of a long vertical spread and the sale of a further out-of-the-money (OTM) vertical spread sharing a common center strike and equal strike price separation. A broken wing butterfly (BWB ) is the same as a butterfly; however, the sold spread is typically wider than the purchased spread. You can also think of a BWB as simply the sale of a ratio call or put spread with a far out-of-the-money tail incorporated into the mix for the purpose of risk and margin reduction.


As you compare the two OEX spreads in the above table, you will see that the traditional $10 wide butterfly on the left costs 90¢ and has the possibility of making as much as a $9.10 profit. However, the spreads often expire worthless, which would result in a $90 loss for every spread purchased. The BWB, however, can be initiated for zero premium. You also will notice that the BWB can be thought of as the purchase of a $10 put vertical (520-510) and the sale of a $15 put vertical (510-495).

You are trading one form of risk for another. In other words,  you are ridding yourself of the 90¢ premium risk associated with the purchase of the traditional butterfly in exchange for a short far OTM put spread at the 500-495 strikes. The risk associated with the short spread is considered to be less than the risk of putting up 90¢. “A better mouse trap” will help you visually understand what is going on with the creation of the BWB.



Alex Mendoza, chief options strategist with Random Walk, has produced numerous books and CDs on options trading. Visit their Web site, www.RandomWalkTrading.com. .........................

"A trader is a man who earns what he gets and does not give or take the undeserved. He does not treat men as masters or slaves, but as independent equals. He deals with men by means of a free, voluntary, unforced, uncoerced exchange—an exchange which benefits both parties by their own independent judgment. A trader does not expect to be paid for his defaults, only for his achievements. He does not switch to others the burden of his failures, and he does not mortgage his life into bondage to the failures of others." - Ayn Rand