How would you like to profit from a stock that you think will rise significantly in the short term while limiting your loss if it tanks? If so, then you should check out the short broken butterfly options strategy.

As the name implies, a short broken butterfly (or short skip-strike butterfly) is based on the iron butterfly strategy. But there’s a crucial difference.

The long iron butterfly is a profitable trade when the underlying stock moves significantly higher or lower. The short iron butterfly is profitable when the stock stays neutral.

With a short broken butterfly, though, you’ll only profit if the stock moves in one direction.

In this guide, we’ll explain the short broken butterfly strategy so you can determine if it’s right for you.

What Is a Short Broken Butterfly?

A short broken butterfly is a multi-leg options strategy that involves four legs with three strike prices. It’s among various “iron butterfly” choices for options traders.

Read This Story: Iron Butterfly Options Strategy Explained (Simple Guide)

First, you sell a call option at the highest strike price.

Then, you buy two call options at the middle strike price.

Finally, you sell a call option at the lowest strike price.

The distance between the lowest and middle strike prices is half the distance between the highest and middle strike prices.

For example, if the lowest strike price is 85 and the middle strike price is 90, then the highest strike price is 100.

The difference between 85 and 90 is 5. The difference between 100 and 90 is 10, or twice the first difference.

As you can see from that example, the strike price of 95 is “skipped.” That’s why some people call the short broken wing butterfly a short skip-strike butterfly.

You can also place a short broken wing butterfly order with put options instead of call options. Just follow the same rules except that you skip the strike price in the lower half of the trade.

In the example above, you’d sell a put option with a strike price of 85, then buy two put options with a strike price of 95, and finally sell another put option with a strike price of 100.

Keep in mind: when you place a short broken butterfly with call options, you’ll profit when the price of the underlying stock rises significantly. When you place a short broken butterfly with put options, you’ll profit when the price of the underlying stock drops significantly.

In either case, you’ll lose money if the stock closes around the strike price of the long positions at expiration. The following video provides details:

When Would You Use a Short Broken Butterfly?

Use a short broken butterfly with call options when you’re bullish on a stock. Use a short broken wing butterfly with put options when you’re bearish on a stock.

Your target price for the stock should be the highest strike price if you’re using call options or the lowest strike price if you’re using put options.

The value of a short broken wing butterfly trade rises and falls with implied volatility (IV). That’s why it’s often a great strategy if you think IV will rise in the near future.

On the other hand, if IV falls, expect to see your money go down the drain.

How Does a Short Broken Butterfly Work?

First, make sure that your trading platform supports multi-leg orders. As I mentioned above, there are four legs involved in a short broken butterfly strategy.

Next, find a stock that you think will move significantly in the near future. Start looking at its options chains.

Find an options contract with a strike price that’s right around your target price for the stock. Remember: look at call options if you expect the stock price to rise and look at put options if you expect the stock price to fall.

Once you’ve done that, identify the other options for the trade.

If you’re using call options, look for contracts with lower strike prices. If you’re using put options, look for contracts with higher strike prices.

Remember: the difference between the lower strike and the middle strike is not the same as the difference between the higher strike and the middle strike.

If you’re using call options, the difference in the higher range should be twice the difference in the lower range.

If you’re using put options, the difference in the lower range should be twice the difference in the higher range.

The expiration dates of all the contracts should be the same, though.

The current price of the stock should be around the lowest strike price if you’re using call options or the highest strike price if you’re using put options.

Real Life Example Using a Short Broken Butterfly

Let’s say that drug giant Bristol-Myers Squibb (NYSE: BMS) is trading at $47 per share right now. You think it’s oversold and will rise significantly in the near future so you’d like to make some money with a short broken butterfly.

You check out next month’s options contracts. Your price target is $53; that’s where you start your search.

The call option for that strike price is currently bid at $1.86. Upon further research, you find that the stock has relatively low implied volatility so it looks like a good trade.

That $53 strike, by the way, will be the highest strike price in the trade. That’s because it’s your target price.

Read This Story: Strike Price Explained (Simple Guide)

Next, you need to find options contracts with lower strike prices.

The options contract with a strike price at $49 is offered at $1.30. You’ll buy two of those options.

Finally, the at-the-money options contract (where the strike price is the same as the current stock price of $47) is bid at $1.86. That’s the lower end of the trade.

This is a good short broken butterfly with call options because the difference between the two lower legs is half the distance between the two upper legs.

The strike prices on the lower legs are $102 and $104. That’s a difference of $2.

The strike prices on the upper legs are $104 and $108. That’s a difference of $4.

Now, let’s go through the whole trade.

You start by selling the option with the highest strike for $0.31 Remember, though, that options contracts are sold in batches of 100 shares each so it earns you $31 ($0.31 x 100 = $31).

Next, you buy two call options at the middle strike price. That costs you $260 ($1.30 x 2 x 100 = $260).

Finally, you sell the call option at the lowest strike price. That earns you $186 ($1.86 x 100 = $186).

If you do the math, you’ll see that the trade costs you $43 ($260 – $186 – $31 = $43).

Let’s say that your prediction comes true and BMS trades at just below $53 when the contracts expire. What happens then?

The two options you bought will be worth around $4.00 each, or $800 total ($4.00 x 2 x 100 = $800). So you make a profit of $540 on that part of the trade ($800 – $260 = $540).

The $53 call option that you sold will expire worthless. You keep all $31 you earned from selling it.

The $47 call option is now worth $6.00. You buy it back for $600, taking a realized loss of $414 ($600 – $186 = $414).

That means your total profit for the whole butterfly is $157 ($540 + $31 – $414 = $345).

Congratulations! You earned a positive return on the trade!

What Are Similar Strategies Related to a Short Broken Butterfly?

Here are a few options strategies similar to a short broken butterfly:

• Iron Butterfly – Similar to a broken wing butterfly but without the broken wing. It’s also profitable when the underlying stock stays within a price range (short) or busts out of the price range in either direction (long).
• Long Broken Wing Butterfly – Very similar to a short broken wing butterfly except that it’s got a bullish outlook.

Short Broken Butterfly Compared to Other Options Strategies

Unlike many other options strategies, a rise in implied volatility works in your favor with a short broken butterfly. That’s why it’s best to place the trade when IV is relatively low.

Also, if you’re completely wrong and the stock moves wildly in the opposite direction of your target price, the risk is minimal. The maximum risk for a short broken butterfly is realized when the stock closes at the middle strike price at expiration.

You can be really wrong with a short broken butterfly with a minimal loss. You just can’t be a little bit wrong or you’ll take a big hit.

Advantages & Risks of a Short Broken Butterfly

Advantages

• Protection against significant movement – If your prediction about the stock price is very wrong and it drops instead of rises (or rises instead of drops), you’re protected with a minimal loss.
• Minimal cash outlay – It usually doesn’t cost a lot to place a short broken butterfly trade.

Risks

• Significant loss possible – If the stock closes at the middle strike price on the expiration date, you’ll realize the maximum loss. On a percentage basis, that will loss will be significant.
• Complex trade – As you might have noticed from reading this guide, a short broken wing butterfly is a complex trade. It’s not for novice investors.