Decoding Broken Wing Butterfly

Among the variety of strategies in options trading, the one that stands out is the broken wing butterfly. Being a variation of the basic butterfly spread, it offers the advantage of potential profitability from moderate market movement in one direction, while limiting the risk from a large market movement in the opposite direction. This strategy allows market participants to potentially realize a profit whether the price of Bitcoin increases, decreases, or remains the same.

The Original Butterfly Spread

The butterfly spread serves as the foundation for the broken wing butterfly. Essentially, it is a four-legged spread involving a combination of calls or puts (depending on whether it's a call or put spread). All the contracts have the same maturity dates but different strikes. For instance, the long call butterfly strategy involves the following steps:

• It starts with the purchase of an in-the-money (ITM) call with a strike lower than the current underlying asset’s price.
• The next step involves the sale (writing) of two at-the-money (ATM) calls.
• Lastly, an out-of-the-money (OTM) call with a higher strike is purchased.

In this case, the highest profit is obtained if the price of the base asset (Bitcoin, for instance) is matching the strike of the short calls upon their maturity. On the other hand, the maximum risk is limited to the net premium paid for the position.

In summary, the original butterfly spread is a neutral strategy, designed to profit from low volatility in the base asset. It offers a limited-risk, limited-profit potential and generally requires the base asset to trade in a narrow range during the life of the options for the strategy to be profitable.

Evolution of The Broken-Wing Butterfly (BWB)

Basically, the broken wing butterfly spread emerged as a way to tweak the original butterfly spread, allowing for more flexibility. In contrast to the original butterfly spread, the “wings” of a broken wing butterfly are uneven, leading to an asymmetric payoff diagram. This intriguing distinction offers a chance of realizing a significant profit while keeping the loss reasonable.

Understanding the Mechanics of Broken Wing Butterfly

As it was previously mentioned, the broken wing butterfly strategy has an asymmetric payoff diagram. It's this asymmetry that allows the strategy to profit more from a moderate price move in one direction, while also providing protection against a large price move in the opposite direction.

Let us go through the procedure of constructing the broken wing butterfly options trade and profitability scenarios depending on the market movement.

Construction of Broken Wing Butterfly

Constructing a broken wing butterfly involves the execution of four unique options: the sale of two contracts at-the-money (ATM), the purchase of one in-the-money (ITM) contract at the lower strike and one out-of-the-money (OTM) at a higher strike than the base asset price. All four positions should be opened consequently.

Unlike in a basic butterfly spread with evenly spread strikes, a broken wing butterfly features one wing that's wider than the other.

To further illustrate this, let's use a hypothetical example on Bitcoin calls. For simplicity's sake, assume Bitcoin is trading at $20,000. We could structure a four-legged Broken Wing Butterfly strategy as follows:

1. Sell two ATM calls each with a strike of $20,000. Assume the premium received for selling each call is $1,500. Let’s label them as CALL 1 and CALL 2, for convenience.
2. Buy one ITM call (CALL 3) with a strike of $19,000. Assume the cost to buy it is $1,250.
3. Buy one OTM call (CALL 4) with a strike of $22,000. The cost to buy this it would be $750.

The total premium received from selling CALL 1 and CALL 2 is $3,000 ($1,500 + $1,500), while the total cost of buying CALL 3 and CALL 4 is $2,000 ($1,250 + $750).

So, the net credit or net gain of setting up the strategy is $1,000 ($3,000 premium – $2,000 cost).

Let's now consider the profit and loss scenarios upon maturity date:

If Bitcoin is below $19,000 at expiration, none of the calls will be in the money, meaning they will all expire worthless. The trader makes a profit in the amount of net credit. In this case, the calculation is as follows:

• Net Credit = $1,000
• Total Gain = $1,000

If Bitcoin is between $19,000 and $20,000 at expiration, only the in-the-money call (CALL 3) will have intrinsic value. Let's assume Bitcoin is at $19,500 at maturity date. The calculations are as follows:

• Value of CALL 3 = $19,500 (Bitcoin Price) – $19,000 (Strike Price) = $500
• Total Gain = $500 (Value of CALL 3) + $1,000 (Net Credit) = $1,500

If Bitcoin is at $20,000 at expiration, the in-the-money call (CALL 3) will be worth the difference between Bitcoin's price and its strike price. The other calls will expire worthless. The calculation is as follows:

• Value of CALL 3 = $20,000 (Bitcoin Price) – $19,000 (Strike Price) = $1,000
• Total Gain = $1,000 (Value of CALL 3) + $1,000 (Net Credit) = $2,000

If Bitcoin is between $20,000 and $22,000 at expiration, then CALL 3, CALL 1 and CALL 2 will have intrinsic value. Let's assume Bitcoin is at $21,000 at maturity date. The calculations are as follows:

• Value of CALL 3 = $21,000 (Bitcoin Price) – $19,000 (Strike Price) = $2,000
• Loss from CALL 1 and CALL 2 = 2 * ($21,000 (Bitcoin Price) – $20,000 (Strike Price)) = $2,000
• Total = $2,000 (Value of CALL 3) – $2,000 (Loss from CALL 1 and CALL 2) + $1,000 (Net Credit) = $1,000

If Bitcoin is above $22,000 at expiration, all the calls will have intrinsic value. Let's assume Bitcoin is at $23,000 at maturity date. The calculations are as follows:

• Loss from CALL 1 and CALL 2 = 2 * ($23,000 (Bitcoin Price) – $20,000 (Strike Price)) = $6,000
• Value of CALL 4 = $23,000 (Bitcoin Price) – $22,000 (Strike Price) = $1,000
• Total = $4,000 (Value of CALL 3) – $6,000 (Loss from CALL 1 and CALL 2) + $1,000 (Value of CALL 4) + $1,000 (Net Credit) = $0

These examples demonstrate how a four-legged broken wing butterfly strategy can offer a more flexible profit potential, particularly if the price of the underlying asset (Bitcoin in our case) moves moderately in the expected direction.

However, it's important to remember that this strategy also comes with a higher risk potential, particularly if the price of the underlying asset moves significantly beyond the strike prices of the options.

How Do I Set Up A Broken Wing Butterfly?

As we explored the mechanics of the broken wing butterfly in different scenarios, let’s sum up the strategy setup:

1. Select your asset: for example, Bitcoin.
2. Pick your strike prices: one below the current price of Bitcoin (long ITM call) two near the current price (short ATM calls), and one above the current price (long OTM call).
3. Determine the expiration date, which is contingent upon your analysis of potential market movements.
4. Execute the trades: buy one ITM call, sell two ATM calls, and finally buy one OTM call.
5. Monitor your position. It’s crucial to stay alert to Bitcoin's price movements and adjust your strategy accordingly.

These are the essential steps required to set up a Broken Wing Butterfly strategy. Please keep in mind that this approach should be used by traders who have a solid understanding of options trading and are comfortable with its inherent

Factors to Consider When Selecting an Asset

It’s paramount to spend some time to select a proper stock before executing your trade. And in the case of such volatile asset as cryptocurrency, rigorous market analysis is especially required.

Overall, traders need to consider aspects such as historical volatility, implied volatility, liquidity, and any upcoming news or events that might affect the asset’s price. Additionally, traders should consider their risk tolerance and investment goals when deciding whether to implement a broken wing butterfly strategy.

What’s The Goal With A Broken Wing Butterfly?

The primary objective of a broken wing butterfly strategy is to magnify potential profits while maintaining a degree of risk control. This strategy can be particularly effective when a trader expects a substantial directional move in the price of the underlying asset, but also desires to hedge against the possibility of the asset price moving in the opposite direction.

This strategy offers a balance of risk and reward, and can be an effective tool in a trader's arsenal. However, like all trading strategies, it requires a sound understanding of the underlying principles, as well as careful planning and diligent risk management.

Managing The Trade

Just like with any other strategy, it is important to consider possible scenarios with your trades to manage your trade properly. First, set up the profit level you are aiming for. Typically, traders would not close the positions until they see at least 25-50% of the maximum possible profit. As a rule of thumb, the broken wing butterfly reaches its maximum potential around the strikes of short calls.

Besides the profit target, it is crucial to set up a stop-loss or closely monitor the trade to be able to close it when the strategy goes against you. A good rule of thumb is to base the stop-loss on a percentage of your capital at risk. This percentage may range from 20% to 30%.

Risk Management Techniques

Successful trading is as much about managing potential losses as it is about maximizing profits. Besides setting a stop-loss, that we discussed above, here are more risk management techniques that can be applied in the context of a broken wing butterfly strategy:

1. Position sizing. Ensure the size of your position doesn't exceed a small percentage (commonly 2%) of your total trading capital.
2. Diversification. Spread your trades across various assets and strategies to lessen the potential blow of a single trade going south.

Adjusting The Trade

Regularly review and adjust your position as necessary, especially considering the potential for Bitcoin's price to shift substantially. These adjustments might involve closing a portion of the trade, changing the strike prices, or even altering the expiration dates to cater to the new market conditions.

Broken Wing Butterfly Pros and Cons

In order to summarize the main information we have discussed so far, let’s break the strategy’s features into advantages and disadvantages.

Advantages:

1. Limited risk. The maximum loss is typically the amount of net debit paid to establish the trade (if entered for a debit), or it could be zero or a small net credit (if entered for a credit, as in our example).
2. Profit potential, which is realized in three scenarios: if the price of the base asset stays the same, moves slightly against your position, or moves in your favor.
3. Flexibility, i.e., the strategy can be adjusted to balance the probability of profit versus potential return. By widening the unbalanced side of the spread (the “broken wing”), you can increase the probability of a profitable outcome at the expense of potential return.

Disadvantages:

1. Complexity. Multiple-leg strategy which includes options with different strikes can make it difficult for less experienced traders to add this strategy in their trading routines.
2. Costs. Because the strategy involves four options contracts, transaction fees can be higher than simpler strategies.
3. Unbalanced Risk/Reward. While the strategy has the potential for a higher profit in comparison to a regular butterfly, it also shifts the risk entirely to one side.

So How Do I Begin?

Embarking on the journey of employing the broken wing butterfly strategy necessitates a strong foundation in understanding the mechanics of options trading. Armed with this knowledge, now you can first choose a trading platform and an asset. Then, begin analyzing market conditions, developing a trading plan, including potential adjustments, and subsequently placing the trade.

Conclusion

In wrapping up our deep dive into the enthralling world of the broken wing butterfly strategy, it's evident that despite its increased risk, this approach offers traders the possibility of sizable profits. The unique, asymmetrical structure of the strategy, a deviation from the standard butterfly spread, gives it its unique set of benefits and challenges.

FAQ

What Is the Risk Level of a Broken Wing Butterfly Strategy?

The strategy carries a moderate to high risk due to its complexity and potential for substantial price movements in the underlying asset. It's typically established for a net credit, with the maximum risk being the difference between the strikes of the long and short options minus the net credit. This strategy is suitable for traders with a deep understanding of options and a high risk tolerance.

How Does the Broken Wing Butterfly Strategy Work With Bitcoin Trading?

This strategy can be applied to Bitcoin trading much like any other base asset. However, the inherent volatility of Bitcoin can lead to higher premiums, and consequently, potentially larger profits or losses. This adds another layer of complexity but also opportunity for the informed trader.

Can I Use a Broken Wing Butterfly Strategy for Long-Term Bitcoin Investments?

Typically, this strategy is used for short-term trading. However, it can be adapted for long-term Bitcoin investments. This typically involves choosing options with longer expiration dates and managing the risk over an extended period. This way, the strategy can be a powerful tool for long-term investment goals as well.

*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.