How To Trade A Butterfly Spread With No Potential For Loss


Hey everyone. This is Kirk, here again at
optionalpha.com. And in today’s video, I want to show you guys exactly how we turned a broken
wing butterfly into a regular butterfly, with no downside loss, total upside profit potential.
So at this point, we have a regular butterfly on that we had hedged into via a broken wing
butterfly. And now, we have a position that will not lose money, no matter where the stock
trades, and actually should make us a pretty decent profit regardless. So, I’m going to
walk through that step by step. And again, I want to start with the broken wing butterfly,
how we created that position in the first place, and then walk you through how we got
to the regular butterfly, so that you guys understand that logic and how we made those
trades. So, right here is just a very simple profit
and loss diagram for a broken wing butterfly. So again, I’ve gone over this a couple of
times in the other videos, but just to recap what you do on a broken wing butterfly. And
in this instance, it’s a put broken wing butterfly, so we’re just trading puts. But you’d buy
one of the D strike puts and that creates this profit loss, until you get to point C
or C strike where you would sell twice as many of the options that you bought here at
D. And you can see that’s pretty evenly spaced, so it’s just probably the next strike price
down. After that, this is where the broken wing
comes into play. You actually skip over strike B. So in this case, we go all the way down
here to strike A and we’d buy another put down here at strike A, and this creates this
long end of the profit loss diagram or this broken wing, and that’s because you’re skipping
over a strike. So, if these strikes are $5 wide, you’d make this difference here $10.
If C and D are $1 wide, you’d make this difference here $2 in strike price, okay? So, that’s
a very simple explanation of what the broken wing butterfly is. Now, let’s look at the trade that I initially
put on in the trading alerts for members. Again, this only went out to members, so you
can’t get these unless you subscribe at optionalpha.com. But the initial trading alert was opening
and we bought two, such as how many butterflies we bought, EEM December 13, 2013 options.
But here’s where the strike prices come into play. So, we bought the 42 and we sold the 41’s,
and then you can see, we skipped over the 40’s and we went all the way down to the 39’s
and bought the 39’s. So the 42’s, the 41’s, and the 39’s. This altogether, created a credit
of $.12 per butterfly. So not a huge credit, but what that did is allowed us to at least
lock in a profit should EEM trade anywhere above, say basically 40 at expiration. But here’s what happened. EEM started trading
higher, so what we did is we actually bought back this embedded vertical that was missing.
So, remember I keep talking about this missing strike price that you skip over with a butterfly.
And this is how you turn that broken wing butterfly into just a regular butterfly with
total upside potential. So down here, you can see what alert went out to members just
the other day, and that was to hedge this trade by buying the vertical in EEM. Again,
the same December 2013 options. And here’s the difference. In this instance,
we bought back the embedded vertical which was the 40 (that missing strike price) and
the 39. So, we closed out the 39 and established a new strike at 40. This altogether, total,
cost us $.11 per vertical. So, you can see we originally took in $.12 in credit and it
cost us $.11 in debit to actually hedge this trade, and so, we still have $1 left over
at the very least. But you’ll see here shortly on our profit loss diagram that we actually
have a very good position where we have no downside potential in this butterfly. It’s
a total 100% upside potential for EEM. So, let’s go to the actual chart here. This
is a look at my actual trading platform. And I’ve thrown in the simulated trade here that
we’d made that hedge trade just to show you guys what we did as far as the original trades.
So, this is a profit and loss of the original trade that we made. And I’ll go through it.
So again, you can see here we bought the 42’s, and that was here. That kind of pins this
breakeven point all the way out here at past 42. We bought the 42 puts, then we came up
to the 41’s, sold twice as many 41’s, we skipped all the way over that 40 strike and went all
the way down here to 39 and bought 39 puts. So, this is the original profit and loss diagram
that we had on this broken wing butterfly. Again, you can see, we leave that upside potential
here because we took in a credit on the trade. But what we did is when we hedge the trade,
we got rid of these 39’s. So, these 39’s that are down here that we originally bought, we
closed out that order and we opened a new order right down here at 40. And what this
does is this creates a profit loss diagram that looks like your regular butterfly. So
again, I’m going to remove this trade, so I can show you the original or now the new
trade that we have on right now. So, this is the result the new butterfly that
we have on. We still have the 42 strikes right here. We are still short. The 41’s twice as
many as the 42’s. And then you can see here we now have moved our further strike from
the 39’s to the 40’s. This creates this very natural, normal butterfly graph that you’re
looking at. But if you look here on our profit loss on the downside, there is no possible
area where we actually lose money on this trade, so it’s completely free, and that’s
because we bought back that embedded vertical for the same price or less as the total credit
that we took in. So now, this is a butterfly that only cost
us about $1 in credit. So, we have $1 in credit built-in, but no matter where the stock trades,
we’re actually going to make money on this trade regardless of where EEM trades. So,
our ideal position obviously, would be to hold it until it gets very close to this 41
strike, and that’s where we start making a lot more of our money in this butterfly. So,
we’re going to hold this trade pretty close to expiration, unless EEM starts trading very
close to 41. And then at that point, we’ll close it out for a nice little profit. So, that’s what the broken wing butterfly
looks like. And now, what the broken wing has turned into is just a regular butterfly
with no downside potential and total upside profit. So hopefully, that was really easy
to follow and understand. As always, if you have any questions or comments, please add
them right below to the video. And happy trading!

3 Replies to “How To Trade A Butterfly Spread With No Potential For Loss”

  1. Am I correct that the stock price was higher than $41 when the original BWF was put in place? In other words, the BWF would become profitable as the stock dropped toward $41?  And, when the stock went higher, it created an opportunity to put on the new vertical with a guaranteed profit? I was trying to figure out where the stock was in price at both points of entry? 

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