Execute a broken-wing butterfly with calls

August 31, 2014 07:00 PM

Question:

How do you take advantage of an expected explosive move higher and protect your down side?

Answer:

Execute a broken-wing (split strike) butterfly with calls.

You think a big move higher is imminent. Perhaps you expect a major short squeeze, a climactic upside blow-up or just a major move up. An individual stock may be a ripe takeover plum just waiting to be plucked.

But, you are a prudent trader/investor and wish to have a controlled known risk strategy. Well, I have just such a strategy for you. It’s a variation on the broken wing (also known as the split strike) butterfly using calls. Except that it’s inverted and looks like this:

You are short one at-the-money call, strike A. You are long two calls at strike B, you skip strike C and sell one call at strike D. You’d like to do this spread for a net credit so that if the move never comes or the stock moves lower you still make money. This gives you two breakeven points: Strike A plus the credit or strike C minus the credit received. Your perfect expiration is right on strike D. That means that your maximum profit is strike D minus strike C plus the net credit.

The further apart the strikes are the easier it will be to do this for a credit. But, as in any options strategy, your maximum loss is expiration on your long strike, or strike B minus strike A minus the credit received. The wider the distance between your strikes also means that you need a big move higher to avoid a loss. Actually, even though it’s a bullish play, a small upside move is your worst case scenario. You really don’t want the stock or index to creep higher and then die right on strike B.

This is also a position that benefits from an increase in implied volatility. You really do want an explosive move higher, to strike D or even beyond.

Selling strike D is what makes this strategy different from a simple 2 by 1 call back spread. It makes the play more affordable but does cap your upside potential.

If the stock stays between strikes A and C, time decay hurts you because your profit will erode as the long strike B wastes away. However, if the stock moves above strike B and approaches strike D, time decay begins to work in your favor.

Here’s a current example. As of this writing (Aug. 11 at 10:30 EDT) Time Warner (TWX) is beginning to show some life after puking gains from the failed takeover attempt by Newscorp.

The stock is trading at $74.10. You sell one September 75 call at $2 (strike A); you buy two September 77.50 calls at $1 (strike B). You skip the 80 call (strike C) and sell one 82.50 call at 50¢. The entire trade is done for a 50¢ credit. If TWX is below $75 at expiration you pocket the 50¢ credit. You have two breakeven points: Strike A plus the credit (75.50) and Strike C minus the credit (79.50). Your maximum profit is strike D or higher and your maximum loss is expiration exactly at strike B.

Let’s look at an opportunity in the SPY, currently trading at 194.50. You can sell the September 195 call at $3 (A), buy two 196 calls at $1.60 (B), skip the 197 strike (C) and sell the 198 call (D) one time at 75¢. 

This gives you the same 50¢ credit which you make at 195 or below on expiration. Your breakeven points are 195.50 and 196.50. Your maximum profit is an expiration at 198 or higher and your maximum loss is an expiration exactly at 196.

So, there you have the Inverse Split Strike Butterfly using calls. This is a well-hedged, well-defined strategy to use when you expect a big move up in the near future.

Randall Liss is a veteran options trader. He helped found the European Options Exchange in Amsterdam (now part of Euronext), was a market-maker for that exchange and is co-founder of The Market-Makers Association. Since 2006 Liss has educated and mentored traders.

About the Author

Randall Liss is a veteran options trader. He helped found the European Options Exchange in Amsterdam (now part of Euronext), was a market-maker for that exchange and is co-founder of The Market-Makers Association. Liss has educated and mentored traders since 2006.