Broken Wing Butterfly: Turning a Long Butterfly Spread into a Credit Spread

A butterfly spread is a common choice among sophisticated option traders who anticipate a stock’s price to be at or close to the butterfly’s short strike prices at expiration. The butterfly spread is typically put on as a debit, meaning you pay a net premium to initiate the trade. (For an introduction to the butterfly spread, read this primer.)

But if you make one small adjustment to the butterfly, you turn it into its cousin—an unbalanced, or broken wing, butterfly—with an entirely different risk profile. If structured properly, this spread can be initiated at a credit, meaning you initially receive a premium, minus transaction costs.

For these examples, let’s assume the underlying stock is trading at $70, and the call option chain looks like this:

The Basic Butterfly Options Spread: Equidistant Strikes

A standard butterfly spread is made up of either all calls or all puts, with three equidistant strikes on a 1x2x1 ratio (see figure 1).

Say you want to trade a butterfly spread with calls. Using the data from the option chain in the table above, you could buy the 75-80-85 call butterfly by buying one each of the 75 and 85 calls (the wings) at their ask prices, and selling two of the 80 calls (the body) at the bid price. With the stock at $70, this butterfly would cost $1.70 + $0.70 – (2 x $1.10) = $0.20 (before transaction costs).

The point of maximum profit for this butterfly spread (and the apex of the diagram in figure 1) is if the stock settles at $80 at expiration. The 75-strike call would, in theory, be worth $5, and the rest of the options would all expire worthless, for a potential profit of ($5.00 – $0.20 initial debit x 100) = $480. And the point of maximum loss? If the underlying stock is on either side of the wings, below $75 or above $85, you’re out the initial debit, $20, plus transaction costs. Keep in mind, however, that short options can be assigned at any time up until expiration regardless of in-the-money amount.

What’s Your Position?

It’s worth noting, however, to be aware of the risks as expiration approaches. Depending on where the underlying stock settles on expiration day, you may be left with a stock position, as shown in the table below.

Please note that transaction costs, including exercise and assignment fees, may vary depending on your brokerage firm. At TD Ameritrade, $0 commission applies to online U.S. exchange-listed stock and option trades. A $0.65 per options contract fee applies to options trades with no exercise or assignment fees.

Unbalancing (“Breaking”) the Wing 

If you’re comfortable with a stock position, or the risk of getting a stock position, fine. But if the underlying stock is near the 80-strike as the option expires, you may not know if you’ve been assigned until after the close, so you must wait until the next trading day to cover your position. Plus, exercise and assignment costs may be higher than standard commission rates. Some option traders choose to unwind such positions before expiration to help avoid these risks.  

So, here’s where that one little adjustment comes in. Suppose you wanted to initiate this spread at a credit instead of a debit. One idea is to choose a higher (and thus less expensive) strike for that last leg. This may allow you to collect an initial premium, as shown in figure 2, but it will also expose you to more potential risk.

Referring back to the prices in the option chain in the table, assume that instead of buying the 85-strike call for $0.70 as the far wing, you bought the 90-strike call at $0.35. It’s cheaper, it turns the trade into the 75-80-90 broken wing (or “skip-strike”) butterfly, and instead of paying $0.20 for the butterfly spread, you could take in a credit of $0.15 (with the multiplier, that’s $15, minus transaction costs).

In theory, if the stock is below $75 at expiration, instead of losing the price paid at order entry, you get to keep the premium received after transaction costs. That’s why some traders might use a broken wing butterfly as a substitute for an out-of-the-money (OTM) vertical credit spread. But, unlike credit spreads where the maximum profit potential is limited to the entry credit, broken wing butterflies retain the profit potential of the regular butterfly. With this example, for instance, if the stock settles at $80 at expiration, the maximum profit of this broken wing is potentially $5 plus the entry credit of $0.15 (or $515 with the multiplier), minus transaction costs.

Don’t forget to go through the “if-then” expiration scenarios above but using the 90-strike so there are no post-expiration surprises. Remember the first sentence of this article, which said the butterfly is a common choice among sophisticated option traders.

It’s Not All Roses

Breaking off, or unbalancing, that wing brings you something you might not want—added risk. Because you’re moving the wing further OTM, you’re increasing your risk. For every dollar you move the wing further away, you increase the risk by $1 ($100 with the multiplier). So, in this example, moving the highest wing from the 85-strike call to the 90-strike adds $500 of risk, for a worst-case scenario of ($500 – the $0.15 initial credit) = $485, plus transaction costs. For a graphical representation, see figure 3.

And one other thing—a debit butterfly, with equidistant wings, will generally incur no additional margin requirements. When you break a wing or skip a strike, it’s considered a debit spread and a credit spread, so you’ll likely be required to post additional margin.

Is breaking the wing for an extra credit worth the added risk? That’s for the trader to decide. Some traders will set the middle strike of the broken wing at the far end of their expected range for the underlying stock. That way, it would take a bigger-than-expected move to get the stock to that “danger zone.” And if it does, it may make sense to close the trade early.

Broken wing butterflies aren’t appropriate for every investor, every market, nor for every level of implied volatility. But understanding the mechanics of the strategy can be the first step in deciding whether it’s right for you.