In a Butterfly Spreadstrategy, all of the expiration months are the same. A trader buys a call with a low strike price, sells two calls at the next strike and finally buys a call above that strike. This trade will be done for a net debit. For example, you would buy a $50 call, sell two $55 calls and buy a $60 call. This creates a call debit spread (50 – 55) and a call credit spread (55 – 60). Ultimately, the trader wants the stock to drift up to the middle strike price and stop. Then the call debit spread will max-out and the call credit spread will expire worthless. This same trade can be constructed a few different ways. The trader could sell a low priced put, buy 2 middle strike puts and sell a high priced put. Using the example above, you would have a put debit spread (60 – 55) and a put credit spread (55-50). The risk/reward profile is the same. You want the stock to finish close to $55 so that the debit spread maxes out and the credit spread expires worthless. Although it is less common, you could also sell the 50 – 55 put spread and sell the 55-60 call spread. These are all equivalent positions.
Butterfly spreads are effectively executed by Market Makers because they establish one leg of the butterfly at a time. They are buying on the bid when their bid quote is hit and they are selling on the offer when their offer is lifted. They don’t do it intentionally, because they are just buying option bids and selling option offers across the entire options market. However, when they pair off their positions during the day and this option strategy matches their bias, they will run with the butterfly spread position and they are in at a VERY good price. An individual trader can’t navigate the option bid/ask spread as effectively because they are not dynamically updating their markets on a minute to minute basis.
That doesn’t mean an individual can’t use this option strategy effectively. They simply don’t have the same edge as Market Makers. I’m not a huge fan of the strategy because it is commission intensive and the stock has to cooperate perfectly – not too hot, not too cold.