Broken Wing Butterfly and Option Greeks

Gamma represents the rate of change of an option’s delta. An option with a gamma of +.
05 will
see its delta increase by +.05 for every 1 point move in the underlying.
Delta neutral trades don’t stay neutral for long and the reason is gamma. To understand how
gamma works, let’s look at an example. Assume you buy a 30 day, 50 delta straddle and a 90
day, 50 delta straddle. Both positions have the exact same delta, so how will they perform if the
stock moves? The one with the highest gamma will do better, in this case the shorter dated
trade.
Gamma is at its highest with at-the-money options. Looking at SPY call options with 16
days to expiry, you can see the gamma is highest around $161 – $163. From this you
can deduce that at-the-money butterflies have a large (negative) gamma risk.
Key Takeaways:
1) Delta is highest in deep ITM options

2) Delta moves lower option strike prices are ATM or OTM
3) Gamma lower for ITM options but is highest with ATM options. If the stock price gets deeper
into the money, the Delta increases substantially
Gamma will be higher for shorter dated options as you can see below. Gamma for the
July at-the-money calls is around 0.08 whereas the September at-the-money calls are
0.03. For this reason, the last week of an options life is referred to as “gamma week”.
Most professional traders do not want to be short gamma during the last week of an
options life.
Net sellers of options will be short gamma and net buyers of options will be long
gamma. This makes sense because most sellers of options do not want the stock to
move far, while buyers of options benefit from large movements.
A larger gamma (positive or negative) leads to a larger change in delta when your stock
moves.
When trading butterflies, it definitely pays to keep an eye on gamma. When the stock is
outside the wings of a butterfly, the trade has positive gamma. This indicates that the
trade will gain delta as the price rises and lose delta as the price falls.
When the stock is right at the middle strikes you have a large negative gamma
exposure. A large negative gamma means you don’t want the stock to move far. This
makes sense for a butterfly when you are right at the middle strikes.
As the stock moves up from the short strikes the butterfly will lose delta (and probably
go from neutral delta to short delta as we discussed above). As the stock falls from the
short strikes the butterfly will gain delta (going from neutral to positive delta).
Broken Wing Butterflies
Today we’re looking at the “one-size fits all” strategy that is broken wing butterflies.
Along with directional butterflies, broken wing butterflies are one of my favorite
strategies. How would you like a trade that provides income if a stock goes one way,
and capital gains if it goes the other way? That’s the potential you have with broken
wing butterflies.
A broken wing butterfly is sometimes referred to as a “skip-strike” butterfly and you will
understand why once you see the trade setup. A regular butterfly has the bought
options an equal distance from the sold options, whereas a broken wing butterfly will
skip a strike on one side of the trade. This reduces the cost and in some cases will
actually result in a net credit meaning you can use it as an income trade.
The other way to think about broken wing butterflies is that they are simply an out-of-
the-money credit spread, protected by a slightly narrower, closer to the money debit
spread. This is what the payoff diagram looks like:
Note that there is a (albeit small) income portion to this trade if SPX stays below 1670
and the typical butterfly profit zone located between 1670 and 1690. The drawback with
this trade is the increased risk on the upside, but keep in mind the index has to go
through the profit zone before entering this danger area. Ideally you want the index to
slowly drift up into the profit zone and expire around 1680. However, you also don’t
mind if the index drops in which case you would just let the entire trade expire worthless
and bank the income portion of the trade.
The above example is using SPX and assumes you are slightly bearish due to some
overhead resistance, but are concerned that momentum may carry the index slightly
higher. The income portion of the trade is $100 and the risk is $900 which is an 11.11%
return. Not bad considering you will make this return if the stock:
– Moves lower
– Stays flat
– Rises by less than 2.75%
Let’s not forget you also have the potential to make a large gain within the profit zone.
The upper breakeven point of the profit zone is around 4% higher than the current index
price so you have a reasonable margin for error. The best time to make these types of
trades is at the end of a long bull run, where the stock or index is almost exhausted, but
could potentially muster another 2-3% rally. If that happens, you are in the profit zone. If
the stock reverts to the mean, you bank the income portion.
Hopefully you can now see why I love this trade. Here is how the above SPX trade was
set up:
Date: July 5th 2013,
Current Price: $1624
Trade Details:
Buy 1 SPX Aug 15th $1670 call @ $9.85
Sell 2 SPX Aug 15th $1680 calls @ $7.25
Premium: $100 Net Credit
Let’s take a look at the same idea but using a standard butterfly. Instead of buying the
1700 call for $3.65, this time we are buying the 1690 call for $5.30. The increased cost
of the 1690 call results in a net debit for the trade, albeit only a small one.
Trade Details:
Premium: $65 Net Debit
You might be able to better visualize the different trade setups using this table below
With the directional butterfly you risk the prospect of full capital loss anywhere below
1670 or above 1690. With the broken wing butterfly, you profit anywhere below 1690, so
the probability of success is significantly higher.
The broken wing butterfly also turns the trade into more of a bearish trade as you will
see from the option greeks.
VARIATION – UNBALANCED BROKEN WING BUTTERFLIES

Aggressive traders can use the features of a broken wing butterfly and take them to the
next level by trading an unbalanced broken wing butterfly. The idea is that you have
your regular broken wing butterfly and then add extra short vertical spreads. You could
also call this a ratio spread with out-of-the-money protection.
This type of trade increases the income potential, but also increases the risk, which is
why I mentioned that it is more suitable for aggressive traders.
Using our SPX example, we can increase the income potential to $460, the trade-off
being an increase in capital at risk to $2540. Still that is an increase in the income
portion of the trade from 11.11% to 20%. Here’s how you would set up the trade:

Trade Details:
Premium: $460 Net Credit
The unbalanced broken wing butterfly becomes more of a directional trade than the
other two as you can see from the greeks below. You still get the nice profit zone on the
upside if the stock continues to rise, but this trade is much more bearish due to the
negative delta.
With the unbalanced broken wing butterfly, all of the greeks are significantly higher than
the other two trades. Still it’s a great strategy but it might take some getting used to. You
can read more about this strategy online at the Futures Magazine.
We covered some pretty difficult concepts here, so if you have any questions, please
98803 54175 drop me a line.

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Gamma represents the rate of change of an option’s delta. An option with a gamma of +.

1) Delta is highest in deep ITM options

VARIATION – UNBALANCED BROKEN WING BUTTERFLIES

Date: July 5th 2013,

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