Hello again everyone, I hope today you’ll commit to making Jesus and faithfulness the foundation from which everything else begins! I know you won’t be disappointed. If you’re interested, here is a link from Biblestudytools.com with more on making Jesus our foundation.
Having said that, let’s take a few minutes to unbox an incredibly short term broken wing butterfly trade I’ve recently uncovered. Admittedly, I haven’t found much success with butterfly spreads myself but I’ve also never traded them on a weekly, or even a daily basis like this. Finally, here is Nasdaq.com with a full breakdown of the butterfly spread to fill in any gaps I may miss.
In theory, the strategy works quite well but does it stand up in real time?
Let’s find out…
Post Agenda
- What is a broken wing butterfly spread?
- Why trade the broken wing butterfly when a simple debit spread would suffice?
- Backtest comparison: Debit Spread vs. Broken Wing Butterfly
- When to use the broken wing butterfly be utilized?
Broken Wing Butterfly Options Strategy
The broken wing butterfly or as it’s increasingly known, the BWB, is an an advanced options strategy seeking to eliminate the risk to one side of the market. Several variations of the strategy exist but for today’s post we’ll be primarily focused on a broken wing butterfly using calls to create a “debit spread”. A debit spread is simply a strategy with a defined risk outcome and an initial capital outlay.
The broken wing butterfly intentionally avoids the symmetry of a traditional BWB strategy. Thus creating a payoff diagram that completely eliminates risk of loss to one side of the trade. For illustration, below is an example of the broken wing butterfly strategy we’ll be considering today.
The structure or construction of this trade is as follows;
- First leg – Long ITM $5595 Call
- Second leg – Short x2 ITM $5610 Call
- Third leg – Long ATM $5620 Call
Notice the second leg is comprised of two short ITM calls, meaning from the outset of the trade assignment risk is a concern. Therefore, the debit spread broken wing call butterfly is better suited to index options that our European style. Since European style options cannot be assigned earlier than expiration. Common index options are SPX, RUT, NDX, or more recently, XSP.
Lastly, the key benefit in my opinion, is the initial capital outlay. With this strategy, similar to a common debit spread, the trader cannot be met with additional losses no matter what the market may do. From a risk management perspective, this makes determining position sizing, stop losses, or profit targets considerably easier. Additionally, here is a list of all videos I’ve completed. You may find the one over butterfly spreads helpful.
Why trade the Broken Wing Butterfly instead of a Debit Spread?
The first and most obvious benefit is the peak profit tent of the BWB when compared to the debit spread. In this instance, the bwb offers a max profit of $1095 vs the max profit of $610 for the debit spread. However, the peak profit of the broken win butterfly shouldn’t be a target outcome because the price would need to pin the short strike at expiration. Said another way, this isn’t likely to happen. It is though, a notable difference so I mention it here.
The next benefit to the BWB lies in the outcome probabilities. Take notice that this similar priced debit spread requires moving out of the money a considerable distance. Essentially making the trade a loss from the outset unless price moves in our favor. The BWB example above is very near maximum profit from the outset and should the market do nothing we’ll make money from theta decay.
The last difference I want to mention has to to with the T+0 line. The magenta or purple line that run’s horizontally through each payoff diagram. Pay attention to the slope of each line. The BWB offers a flatter line which basically means that as price moves up or down, the profit loss isn’t impacted as heavily. The debit spread T+0 line has a steeper slope. To state this dynamic another way, the BWB would lose $11 if the underlying fell by $5 and the debit spread would lose $35 on the same $5 down move. Similarly, a $10 point downward move would result in a $62 loss for the debit spread while the BWB loses $20. Hardly irrelevant from my perspective.
30 day Back-test’s – Debit Spread vs. Broken Wing Butterfly
Back-test #1 – Bullish Market
- Back-test Start Date – June 14, 2024
- Current Market Sentiment – Very Bullish
- S&P 500 Index – SPX
- Target – 3 DTE
- Holding Time – To expiration
| Trade # | Debit Spread P/L Outcome | Broken Wing Butterfly P/L Outcome |
|---|---|---|
| 1 | ($225) | $225 |
| 2 | ($356) | $277 |
| 3 | $50 | $150 |
| 4 | $470 | $85 |
| 5 | $545 | $100 |
| 6 | $295 | $60 |
| 7 | ($110) | $245 |
| Total | $669 | $1142 |
Back-Test #2 – Bearish Market
- Back-test Start Date – September 5, 2023
- Current Market Sentiment – Bearish
- S&P 500 Index – SPX
- Target – 3 DTE
- Holding Time – To expiration
| Trade # | Debit Spread P/L Outcome | Broken Wing Butterfly P/L Outcome |
|---|---|---|
| 1 | ($450) | ($445) |
| 2 | $515 | ($5) |
| 3 | $197 | $95 |
| 4 | $310 | $35 |
| 5 | ($430) | ($405) |
| 6 | ($53) | $185 |
| 7 | ($425) | ($74) |
| 8 | ($328) | $137 |
| 9 | ($381) | $270 |
| Total | ($1045) | ($207) |
I wanted to test the strategy against both a bullish and a bearish period in the market. As you can see, the results are quite impressive. However, take note that neither strategy would perform well during an extremely bearish decline.
In this instance, we would have achieved $480 more in profit during the bullish phase and avoided $838 of additional loses during a bearish phase. Based on these results, our total for the two periods is; broken wing butterfly $935, and debit spread ($376).
In aggregate, the takeaway from this very small back-test is this; Very bullish? Trade debit spreads. Unsure? Trade the broken wing butterfly.
When Should I use the Broken Wing Butterfly?
Well, that is largely up to the trader attempting the strategy. Ideally, an optimal time to enter this trade would be when we’re neutral to bullish. More so when we’re neutral given the payoff diagram’s profit tent for no price movement.
I think it would be good practice to determine a set of entry parameters such as at a support level or after a positive earnings announcement. Really, anytime you may have a modicum of conviction regarding the market direction.
In total, the strategy may be best utilized at any time. I say that with the understanding we would be trading some strategy even if not the broken wing butterfly. The back test data above would support such a conclusion but more testing is always necessary. If this data were to hold true in perpetuity, it could result in a consistently profitable strategy that holds up well comparatively during bearish swings.
Final Thoughts
The broken wing butterfly options strategy is a unique one, for sure. The strategy holds up well under pressure and performs well during bullish or neutral markets. The profit potential is smaller on a fully bullish move but the trade off comes from the performance consistency. From the testing data above, the debit spread performed incredibly well when the market moved outright higher. However, theta ate away all of the premium from that trade when the market didn’t move. Thus, from a psychological perspective or even a profitability perspective, the BWB makes more sense.
That said, it’s always up to the individual trader or the unique scenario. I don’t have any idea what’s going to happen tomorrow in the market. I could come up with a reasonable assumption but I may well be wrong. In that case, the broken wing butterfly strategy offers the opportunity for profit in 2 of the 3 possible market directions, up and sideways.
Until the next post.
God bless and take care,
Jeff
