Long Broken Butterfly Explained (Simple Guide)
How would you like to earn a healthy return from a stock that you think will rise modestly in the near future? If so, then you should check out the long broken butterfly strategy.
As the name implies, a long broken butterfly (or long skip-strike butterfly) is based on the iron butterfly strategy.
Unlike the iron butterfly, though, a broken butterfly won’t give you a profit if the stock moves in either direction. You only profit if the stock moves in one direction.
In this guide, I’ll explain the long broken butterfly strategy so you can know when to use it in your options trading.
What Is a Long Broken Butterfly?
A long broken butterfly is a multi-leg options strategy that involves four legs with three strike prices. It’s among many butterfly options strategies.
First, you buy a call option at the lowest strike price.
Then, you sell two call options at the middle strike price.
Finally, you buy a call option at the highest strike price.
The distance between the lowest and middle strike prices is usually half the distance between the highest and middle strike prices.
For example, if the lowest strike price is 85 and the middle strike price is 90, then the highest strike price is 100.
The difference between 90 and 85 is 5. The difference between 100 and 90 is 10, or twice the first difference.
As you can see from that example, the strike price of 95 is “skipped.” That’s why some people call the long broken butterfly a skip-strike butterfly.
You can also place a long broken butterfly order with put options instead of call options. Just follow the same rules except that you skip the strike price in the lower half of the trade.
In the example above, you’d buy a put option with a strike price of 85, then sell two put options with a strike price of 95, and finally buy another put option with a strike price of 100.
In either case, the expiration date and underlying stock of the options remains the same. This video provides a handy outline of how the strategy works:
When Would You Use a Long Broken Butterfly?
Use a long broken butterfly strategy when you’re moderately bullish on a stock. The strategy wins if the stock goes up but doesn’t go up too much.
If the underlying stock rises above the highest strike price at expiration, you’ll lose money.
The trade reaches its maximum profit if the stock closes at the middle strike price. So that’s your price target for the stock.
Also, the value of a long broken butterfly trade is inversely proportional to implied volatility (IV). That’s why it’s often a great strategy if you’re both bullish on the underlying stock and think IV will drop in the near future.
On the other hand, if IV rises, expect to lose money.
How Does a Long Broken Butterfly Work?
First, make sure that your trading platform supports multi-leg orders. As I mentioned above, there are four legs involved in a long broken butterfly strategy.
Next, find a stock that you think will rise modestly in the near future. Then, start looking at its options chains for the near future.
Find an options contract with a strike price that’s right around your target price for the stock. Make sure it has relatively high IV or you could lose money even if your prediction is accurate.
Next, find options contracts with strike prices that are both above and below your target price. You want one of each.
Remember: the difference between the lower strike and the middle strike is not the same as the difference between the higher strike and the middle strike.
If you’re using call options, the difference in the higher range should be twice the difference in the lower range.
If you’re using put options, the difference in the lower range should be twice the difference in the higher range.
The expiration dates of all the contracts should be the same, though.
Once you’ve identified the necessary options, place the multi-leg order. Then, wait to see if your trade turns profitable.
Real Life Example Using a Long Broken Butterfly
Let’s say that Apple (NSDQ: AAPL) is trading at $143 per share right now. You think it’s oversold and will rise in the near future so you’d like to make some money with a long broken butterfly.
You check out next month’s options contracts. Your price target is $146; that’s where you start your search.
The call option for that strike price are currently bid at $5.75. Upon further research, you find that the stock has relatively high implied volatility so it looks like a good trade.
That $146 strike, by the way, will be the middle strike price in the trade. That’s because it’s your target price.
Next, you need to find options contracts with lower and higher strike prices.
The options contract with a strike price at $144 will cost you $6.90. That will cover the lower end of the trade.
On the upper end, you need to skip a strike price.
The difference between the middle and lower strike price is 2 (146 – 144 = 2), so the difference between the middle and upper strike price needs to be double that amount, or 4. That means you’re looking for the call option with a strike price of $150 (146 + 4 = 150).
That contract will cost you $4.15.
Now, let’s go through the whole trade.
You start by purchasing the lowest strike price contract for $6.90. Remember, though, that options contracts are sold in batches of 100 shares each so it really costs you $690 ($6.90 x 100 = $690).
Next, you sell two call options at the middle strike price. That earns you $1,150 ($5.75 x 2 x 100 = $1,150).
Finally, you buy the call option at the highest strike price. That costs you $415 ($4.15 x 100 = $415).
If you do the math, you’ll see that the trade actually puts a credit of $45 in your account ($1,150 – $690 – $415 = $45). The trade doesn’t cost you any money (at this point).
Let’s say that your prediction comes true and Apple trades just below $146 when the contracts expire. What happens then?
The two options you sold will expire worthless; you keep the money you earned from them. That gives you a profit of $1,150.
The $143 call option will trade for $3.00. You’ll sell it for a loss of $390 ($690 – $300 = $390).
The $150 call option will expire worthless. You’ll eat a 100% loss of $415 for that leg.
That means your total profit for the whole butterfly is $345 ($1,150 – $390 – $415 = $345).
Congratulations! You earned a positive return on the trade.
What Are Similar Strategies Related to a Long Broken Butterfly?
Here are a few options strategies similar to a long broken butterfly:
- Iron Butterfly – Similar to a broken butterfly but without the broken. It’s also profitable when the underlying stock stays within a price range (short) or busts out of that trading range (long).
- Short Call Spread – A long broken butterfly is basically a long call butterfly with a short call spread.
- Short Broken Butterfly – Very similar to a long broken butterfly except that it’s got a bearish outlook.
Long Broken Butterfly Compared to Other Options Strategies
As with many other options strategies, time decay works in your favor with the long broken butterfly.
Once the underlying stock hits the price range (between the lowest and highest strike prices), you’ll likely realize some profit if it stays there until expiration. Of course, commissions could eat into that profit.
Also, it’s best to place a long broken butterfly trade when implied volatility is relatively high. That’s because the value of the trade increases as IV decreases.
That’s not the case with long call options or long put options. Those trades increase in value as IV increases.
Advantages & Risks of a Long Broken Butterfly
- Time is on your side – Once the trade stays in the price range, time is on your side. As you get closer to expiration, the whole trade becomes more profitable.
- You don’t have to be exactly right – A long broken butterfly is profitable even if you aren’t exactly right about the target price. For example, if the stock is just a dollar or so shy of the target price at expiration, the trade can still give you a positive return.
- High-percentage risk – Although a long broken butterfly can give you very healthy returns, there’s also a significant risk involved. If the stock rises above the highest strike price, you could lose a lot of money.
- Complex trade – As you might have noticed from reading this guide, a long broken butterfly is a complex trade. It’s not for novice investors.