a butterfly is simply two verticals, a credit-spread and a debit-spread, that share a common short-option strike. because the credit offsets part of the debit, they can be very inexpensive and sport a large reward IF the underlying expires in the vicinity of the short option strikes. that's a big 'IF' because the target vicinity is usually a narrow price range. low risk/high reward = low win/high loss, there's no free lunch ... or is there?
here's the risk profile of a typical butterfly trade:
|february spy 'fly|
i would want that because i can get the lottery tickets essentially for free. suppose i am in a cash-covered, short-put trade. say, short the spy feb 149 put, that i sold for $2 a while back. today i can buy back this option for 59 cents and i could roll this position to march but there is a decent amount of time left in february. for a few cents more than the cost of buying back the feb option i can purchase a 'morph' - i buy the feb 150 and 148 puts and sell one more feb 149 put, all for 65 cents. this metamorphizes my trade into a butterfly, but, this is a butterfly that was legged-in for a net credit of $1.29 ($2-.65-.06commissions). by doing so, i lock-in $1.29 of profit and retain a free lottery ticket that could help ease the pain of a retracement.
but it gets better. once i have purchased the morph, the buying power allocated to the original cash-covered put, enough to buy 100 shares of spy at the price of $149 each, is returned to my account because there is no further risk of loss in the trade. with the released buying-power i can initiate a new cash-covered put position in march and continue onward prepared for most of whatever.
now, the lunch isn't really free. i gave up 6 cents and commissions of unrealized profit. however, this is lunch money that could easily be lost in the slop while waiting for a more opportune time to roll and it buys a disproportinate amount of peace-of-mind.