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