Broken wing options strategy: What is it and how to use it?

The broken wing options strategy is a specific approach to trading options, which involves buying both a call and put option simultaneously while skewering the trade in favour of the call option. The goal is to profit from an increase in implied volatility through making the trade appear vulnerable on one side. When done correctly, this strategy can produce substantial profits by capitalising on predictable market psychology.

What is the broken wing strategy?

The broken wing strategy is an advanced options trading technique that involves the simultaneous purchase of both call and put options on the same underlying asset. The trader intentionally structures the trade to make it appear weak or “broken” on one side by buying out-of-the-money options contracts.

For example, you might purchase one at-the-money call option along with one far out-of-the-money put option on the same stock. This makes it seem as if you are expecting the asset to rise while also hedging with puts in case it falls. In reality, the out-of-the-money put contracts are unlikely to pay off. You are skewing the trade to benefit more from the call options.

The purpose of structuring the trade this way is to take advantage of an anticipated increase in implied volatility. As other traders notice the apparent vulnerability in the broken wing trade, they may rush in to capitalise on the perceived opportunity by selling options. This additional market activity pushes up implied volatility, increasing the value of the options you hold.

If done correctly, you can profit substantially from the Vega exposure inherent in holding long options contracts. The broken wing butterfly strategy relies on this volatility skew and the predictable behavior of other traders to profit.

How the broken wing strategy works

To understand how to correctly utilise the broken wing butterfly strategy, it is important to first understand what causes the anticipated volatility skew.

1. Perceived opportunity - When other traders see cheap, far out-of-the-money put options in an otherwise bullish trade, they will rush to sell those puts to profit from what looks like “free money”. Their market activity naturally drives up demand and implied volatility.

2. Uncertainty - The broken structure of the trade makes it appear vulnerable, introducing uncertainty and volatility into the asset price. Other traders see this as an opportunity but also as a risk, further pushing up implied volatility.

As the trader who initiated the broken wing butterfly, you benefit from this activity through the increased value of the long call and put options you hold. Even though the put options will likely expire worthless, you can still profit from their inflated premium.

When to use the broken wing butterfly strategy

The broken wing butterfly options strategy works best under specific market conditions when you expect volatility to increase. The most common situations include the below:

• Earnings reports - In anticipation of an earnings announcement, implied volatility typically rises as traders prepare for potential price swings. Structuring a broken trade beforehand allows you to profit from the volatility expansion.

• Economic data releases - Similar to earnings, major economic data events like employment or GDP numbers can increase volatility as traders react to the news.

• Index expirations - Index options expiration days often come with increased volatility as trading activity spikes. A broken wing trade can take advantage of this.

• Binary events - Mergers, regulatory rulings, product launches - binary events with an upcoming announced date can cause volatility to rise.

Step-by-step instructions to employ the strategy

Now that you understand the reasoning behind the broken wing strategy, let’s go through an example of how to execute it in your own trading.

1. Identify opportunity – Find an asset where you expect volatility to rise soon ahead of an earnings call, data release, product announcement, etc. Analyse historical volatility trends to estimate the opportunity.

2. Leg In gradually – Initiate the trade by first buying an at-the-money call option with a longer expiration (3-6 months). Spread your entry over time to avoid signaling.

3. Add far OTM puts – After going long on the call option, add far out-of-the-money put options with the same expiration. This “breaks” the wing to appear vulnerable.

4. Manage trade actively – As implied volatility rises, manage the trade to lock in profits. You can sell options to close or use spreads to hedge.

5. Close position before expiration – Don’t hold to expiration. Close the trade while Vega is still elevated to maximise profits. Allow time value to decay as volatility falls.

Be sure to control position size, limit risk, and use stop loss orders. Trading options carries more risk than stocks and this strategy uses leverage to magnify profits. Only trade this strategy with capital you can afford to lose and closely monitor the trade.

Pros of broken wing options strategy

• Profits from rising implied volatility

• Defined, limited risk

• Leverage provides potential for greater returns

Cons

• Higher complexity than most option trades

• Requires experience identifying volatility opportunities

• More active trade management required

• Higher commissions from multiple legs

• Risk of volatility changes not materialising

Common mistakes to avoid

• Skewing trade too close to the money – Put options should be extremely improbable to finish in-the-money at expiration.

• Failing to leg into position slowly – Entering the trade all at once projects your intentions.

• Holding too close to expiration – Give yourself time for volatility to develop by using longer dated options.

• Not managing winning trades – Don’t watch profitable broken wing positions turn into losses, actively lock in gains.

• Entering during already high volatility – This strategy works best just ahead of a predicted volatility spike, not after.

• Not controlling position sizing – Scale according to portfolio size and risk tolerance.

Conclusion

The broken wing butterfly option strategy can provide experienced traders with substantial profits by taking advantage of volatility spikes. While complex, the concept of structuring a vulnerable trade to benefit from increased implied volatility is straightforward to grasp. With proper analysis, timing, and active management, a broken wing can skewer volatility in your favour.