Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. Contributing analysis is by senior Optionetics strategist Chris Tyler.
TAKING STOCK OF A BROKEN WING
If I’m bearish on a stock but wish to own shares at lower levels, would an out-of-the-money (Otm) long put broken butterfly through assignment be a win-win spread to consider? I like the idea of participating in larger dollar-priced stocks such as Google (Goog) or Apple (Aapl) for a credit with these two linked but somewhat different objectives in mind. At the same time, I am not completely sure of all the risks involved. Any light you shed on this would be greatly appreciated.
Designing an Otm broken butterfly can serve both your stated objectives of profiting on a bearish move in share price and build a long stock position at lower prices. However, there are no guarantees that if the former condition is met, the other condition of assignment will result in a profitable starting point for accumulating shares.
First, let’s start with the benefits of this position. Unlike the regular butterfly, which uses equidistant bear and bull put verticals in its construction, the broken wing put butterfly will purchase a closer to-the-money and tighter strike, bear put spread relative to a further away-from-the money looser bull put vertical. This design can allow for a credit in entering the position, and quite often does. That amount can be kept in full if at expiration the stock is above the upper wing of the butterfly. The trader can then look to repeat the process for the next option cycle if his or her outlook remains intact.
During the life of the position, the broken wing is also able to realize much quicker and larger profits than a regular butterfly might manage to secure. Profits can begin to accrue if shares stabilize and/or stock and implied volatility decline due to the broken wing’s vertical construction and much larger negative vega versus a regular fly, which might maintain long or short vega but smaller levels of that risk.
As for the risks, short vega in an unfavorable higher-volatility environment can result in larger paper losses during the life of the position. At expiration a trader ultimately maintains a spread, which has a maximum amount of limited risk. But for whatever reason, if the trader wishes to exit or close down the position prematurely and not pursue buying stock, the cost to do so could be a much more expensive proposition than during flat to lower-volatility conditions.
During the life of the position, the broken wing is also able to realize much quicker and larger profits than a regular butterfly might manage to secure. Second, the nature of the broken wing’s design means that acquiring shares via assignment could start off on the wrong foot with the cost basis much higher than where shares are trading in the open market. Remember, the broken wing’s tighter relative profits from the embedded bear put spread begin to get chipped away, point for point, below the shorted strike as shares enter the area of the risk graph dominated by a much larger bull put spread.
Unlike with the regular fly’s identical maximum loss below or above the wings (long strikes) at expiration if shares are below the bull put vertical, a trader will be out the width of that wider spread minus profits from the tighter bear vertical and initial credit received.
To illustrate a recent and slightly positive outcome, back on March 4 with Goog shares near $600, the April 550/540/510 put butterfly with expiration the day after its earnings release was priced for $1.15 credit. If shares stayed above the 550 strike, the credit would be kept. Below $510, the trader would be out $30 from the 540/510 bull put minus $10 profit from the 550/540 bear put and $1.15 credit for a net loss of −$18.85. The reality turned out to be somewhere in between.
Following a disappointing reaction to earnings on Thursday, April 14, shares closed the next day on April expiration at $530.70. To close out the spread for fair value and removing slippage, the trader would have realized a $1.85 profit. The gain is derived by adding the bear put vertical’s profit worth $10 plus the initial credit of $1.15 and subtracting a loss of −$9.30, which is the difference of the current share price and 540, where the trader maintains an extra short put.
By the same token, if the trader decided to take hold of shares through assignment and didn’t close the broken wing butterfly, he or she would be taking ownership of 100 shares from 540 but factoring in a profit of $10 for the 550/540 bear put, plus the credit of $1.15 to reduce the cost basis of the stock to $528.85. That’s an advantage of $1.85 over the open market price of Goog shares at $530.70. However, that ownership is now an unprotected long stock position, which could always prove taxing if further action weren’t taken on April 15. Yes, that was deliberate.