The 'Skip-Strike' Broken Wing Butterfly: A Variation for Wider Profit Zones

The standard broken wing butterfly (BWB) is a effective tool for expressing a directional view with defined risk. However, a lesser-known variation, the "skip-strike" BWB, offers an even greater degree of flexibility and can be used to create wider profit zones. This advanced technique involves using non-equidistant strikes within the butterfly, allowing for a more customized risk/reward profile.

Understanding the Skip-Strike BWB

A traditional BWB is constructed with three strikes, with the distance between the lower and middle strikes being different from the distance between the middle and upper strikes. In a skip-strike BWB, there is an additional "skip" in the strikes, creating a four-strike position. For example, a bullish skip-strike BWB with calls might involve buying the 100 call, selling two 110 calls, and buying one 120 call. This is a standard 10-point wide butterfly. The skip-strike variation would involve buying the 100 call, selling two 110 calls, and buying one 125 call. The upper wing is now 15 points wide, while the lower wing is 10 points wide.

This seemingly small change in the construction of the BWB has a significant impact on its risk/reward characteristics. The wider upper wing creates a larger potential profit zone, but it also increases the maximum potential loss.

The Trade-Offs of the Skip-Strike BWB

The primary advantage of the skip-strike BWB is the wider profit zone. This can be particularly beneficial in volatile markets where the underlying asset is prone to making large moves. The wider profit zone increases the probability of the trade being profitable, even if the underlying does not pin to the short strikes at expiration.

However, this wider profit zone comes at a cost. The maximum potential loss of a skip-strike BWB is greater than that of a standard BWB. This is because the wider wing requires a larger initial debit to establish the position. Therefore, a trader must be willing to accept a higher level of risk in exchange for the wider profit zone.

Another trade-off to consider is the reduced peak profit potential. While the overall profit zone is wider, the maximum profit at the short strikes is typically lower for a skip-strike BWB compared to a standard BWB. This is because the wider wing is more expensive, which reduces the net credit received or increases the net debit paid.

Constructing and Managing a Skip-Strike BWB

The construction of a skip-strike BWB requires careful consideration of the underlying asset's volatility and expected price movement. The width of the skipped strike should be chosen based on the trader's desired risk/reward profile. A wider skip will create a larger profit zone but also a larger potential loss.

Managing a skip-strike BWB is similar to managing a standard BWB. The trader must monitor the underlying's price movement and be prepared to make adjustments if necessary. The wider profit zone of the skip-strike BWB may require a more hands-off approach to management, as the trade has more room to move before it gets into trouble.

Conclusion

The skip-strike broken wing butterfly is an advanced variation of a classic options strategy that offers a unique set of trade-offs. By using non-equidistant strikes, traders can create wider profit zones and customize their risk/reward profiles to suit their market outlook and risk tolerance. While the skip-strike BWB is not for everyone, it can be a valuable tool for experienced options traders looking to add another layer of sophistication to their trading arsenal.