Strategy

Broken HEART Butterfly

Type of Strategy

trading     /     investing

sentiment

neutral

implied volatility

high

description

Broken heart butterfly spreads are a variation of the broken wing butterfly strategy.  Broken wing butterflies are often converted to broken heart butterflies as expiration nears, in the right situation.  A broken heart butterfly is related to a broken wing butterfly, with the adjustment that the overall credit received is reduced to provide a wider maximum-profit zone.  The distance between the spreads are increased to maximize this zone.  This strategy works best in a short time to expiry cycle, generally 2-4 days to expiration.

Set-Up

Using either calls or puts, a butterfly is created, then adjusted to make an OTM short spread that can finance an ITM long spread.  The strategy is established for a net credit that covers the width of the long spread, thus eliminating risk in one direction.  The excess of this credit over the long spread width is minimized to allow for a large maximum profit range between the two spreads.

Expiration is generally established for a cycle less than 5 days.  Often, broken heart butterflies are created as earnings trade with an expiration in the same week as the earnings announcement.

Investors may use broken heart butterflies for underlying stocks that they wish to purchase.  Other strategies that allow for beneficial stock purchases include naked puts, short put spreads, put ratio spreads (front), broken wing butterflies, and risk reversals.  All have costs and benefits in relation to each other, with optimal application in a variety of situations based on the holder’s preference.

example – NVAX

Investor wishes to purchase Novavax stock if it can be acquired for a price of $160/share.  Investor analyzes strategies and wishes to use a put broken heart butterfly.

Put Broken Heart Butterfly: NVAX

1) NVAX Stock at $172

2) In an offensive account (tax-free), sell a 3 DTE $160/$135 put spread for $1.82.

3) In an offensive account (tax-free), buy a 3 DTE $182.5/$185 put spread for $1.42.

4) Net premium received = $0.40.

5) Breakeven = $157.10 ($160 – $2.5 – $0.40)  Maximum Profit = $2.90

6) Maximum loss = $22.10  (Purchase NVAX at $157.10 when NVAX price falls to $135/sh)

management

Traders often establish a GTC BTC order for 25-50% of the maximum profit, $6.5 – $13 in this example.  Note that this profit level at 25% is approximately equal to the net premium received.

If the stock goes against the spread, the long spread portion of the broken wing butterfly can be closed for nearly maximum profit potential.  The remaining short spread can be managed as a simple vertical, with the potential to roll out in time if a credit can be achieved.