How to Trade Option Ratio Spreads (Part 4) 

12/02/2010 12:01 am EST

Focus: OPTIONS

Mark Wolfinger

Educator, MDWoptions

The first three parts in this series on ratio spreads (Part 1, Part 2, Part 3) were published recently on MoneyShow.com.

The “Broken Wing Butterfly Spread”

The broken wing butterfly spread (BWB) is a frequently used strategy for more experienced players.  Today I'll introduce that option strategy to our readers.

In general, any butterfly spread is used when the trader wants to forecast a specific price range for any underlying. It's also created as an adjustment for existing positions (as a risk management play to limit losses or lock in profits).

In the scenario under discussion (ratio spreads), the BWB is constructed to limit losses, which is always a good idea when trading options. Buying options that are relatively far out of the money (OTM) is not done to take a shot at a gigantic market move. Instead, the trade is made to convert a position that is already short naked calls or puts (a ratio spread) into a position that is no longer short any options. In fact, you can always buy an extra contract or two to provide an unlikely, but nice profit when the market makes an unexpected large move. If this concept is not obvious, that's not a problem. Use your broker's graphic software to examine the risk picture. Do not forget to look ahead and examine risk one day prior to expiration.

The BWB differs from a traditional butterfly spread as follows:

Butterfly spread: A trading strategy consisting of the sale of two options along with the purchase of one option with a higher strike price and one option with a lower strike price. Necessary conditions:  All options are of the same type (calls or puts); the options owned are equidistant from the options sold, and all options expire on the same date.

Broken wing butterfly (BWB): Same as above, except that the options bought must not be equidistant from the options sold.

Although these positions frequently stand on their own, they can be traded by conservative investors who would like to trade ratio spreads, but who refuse to own positions with any naked short options.  The BWB comes to their rescue.

The Ratio Spread

Let's say you are bearish on the market and want to make a trade that suits your expectations. Your guess is that the market will fall, but not too far. With RUT (Russell 2000 Index) trading near 673, you decide to buy three RUT Jan 650 puts (@ $8.20) and sell six RUT Jan 630 puts (@ $5.70). This is a 1 x 2 put ratio spread, and you collected a credit of $3.20 for each spread. (Most rookie traders think of this as collecting $960. However, that makes the conversation awkward. It's far easier to refer to this spread—as well as any other—in terms of its lowest common denominator. That's 1 x 2 in this example.)

As discussed in talking about break-even points for ratio spreads, when the market moves too far, you may lose a significant sum. I know that you (the person making this trade) really believe the market can move through 650—that's why you bought the 650 puts. You also believe it will not decline beyond 630—and that's why you sold the 630 puts.

However, if you are correct about direction, but very wrong about magnitude, there is no reason to lose a lot of money. This trade is naked short three puts, and that leaves you exposed to a gigantic loss if and when there is a big market collapse. Why take that risk when it's unnecessary? 

If you take the more conservative approach, you can buy some Jan puts and accomplish these things:

  1. Limit losses
  2. Maintain a cash credit for the whole trade
  3. Earn a profit even when wrong and the market does not decline

You can buy Russell 2000 Small Cap Index (RUT) Jan 590 puts @ $3. Or you may choose to save a bit more cash and take a bit more downside risk by buying a put with a lower strike price.

Such a trade turns your ratio spread into a broken wing butterfly spread. You would own a “3-lot” of the BWB:

Long 3 RUT Jan 580 puts
Short 6 RUT Jan 630 puts
Long 3 RUT Jan 650 puts

Maximum loss occurs when RUT is below 580 at expiration, and that loss is $3,000 (per BWB) minus the credit collected when opening the position.

Why $3,000 (or $9,000 total)? With RUT settling below 580:

The 650/630 put spread—and you own that one—will be worth its maximum, or $2,000.

The 580/630 put spread—which you are short—will be worth $5,000.

NEXT: Two Main Ways to Profit from This Spread Trade

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 There are two main ways to earn a good profit from this spread:

1) Expiration arrives and RUT is well under 650 but above 630. This is the risky way to play because the Jan 630’s would have a good deal of negative gamma (and lots of positive time decay) as expiration day draws near. I don't recommend holding to the end because this is the highest-risk and highest-reward play, and many traders are tempted to hold and hope. I much prefer the next method (less reward and substantially less risk).

2) Hold the position long enough that theta works its magic and erodes the price of the options. You hope to see the market undergo a slow decline, increasing the value of the Jan 650 puts that you own, but not far enough to offset the time decay in the Jan 630 puts.

Under those conditions, you exit the trade, collecting more cash. The profit potential is very dependent on how much time has passed, the current price of RUT, and the implied volatility of the options. In other words, to estimate a profit, you must use an options calculator. 

One good method for establishing a rough idea of when to exit the BWB trade is to make a trade plan just before or after making the initial trade. That plan sets your (flexible) profit goals, as well as the maximum loss you are willing to accept. Those targets make the exit decision easier, especially for the less experienced trader who may be encountering specific situations for the first time.

When the broken wing butterfly works well, deciding when to exit requires discipline. It's always going to be tempting to wait just one more day to collect that time decay. However, the risk of a big move exists as long as you hold the trade. 

One major warning: Don't ignore risk! If RUT approaches 630 far too early for your comfort, then risk of loss mounts (in fact, your trade is probably already under water). Sure, losses are limited, but that is no reason to own a risky position. The thought process is similar to trading any limited-loss strategy, such as the iron condor. Prudent investors take losses by exiting or adjusting the trade to prevent the occurrence of large losses.

The BWB is a stand-alone trade that gives the trader protection against unlimited losses while providing a very good profit when that trader is correct in his/her market forecast. This forecast involves more than direction. In other words, it's not the best choice when very bullish or very bearish.

This post provides the general idea of what a broken wing butterfly is and how it can be used to minimize risk when the trader owns a ratio spread.

By Mark Wolfinger of Options for Rookies

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