Loyal reader and fully paid up subscriber fatbear has requested that I expound on the “butterfly” trade which I have been following in my daily closing note.There is nothing fancy here and what you see is what you get. As we speak the 2 year yields 2.46 percent, the 5 year note yields 3.24 percent and the Long Bond yields 4.65 percent. So to calculate the butterfly spread you note that the 5 year note is 78 basis points cheap to the 2 year note.(3.24 percent minus 2.46 percent.) Put that 78 basis points in the memory function. Simultaneously, the 5 year is 141 basis points rich to the Long Bond. So the 5 year trades 63 basis points rich to the wings. It is plus 78 basis points to the 2 year and minus 141 basis points to the bond. Net those amounts and you get -63 basis points.
Why would someone involve themselves in this multi legged trade. I spent the biggest chunk of my career as a salesman. (As an aside EE Cummings has a great poem with an opening line which reads, “A salesman is an It that stinks excuse”.) So the cynical explanation is that butterfly trades were the invention of a commission salesman because when the client establishes the position it involves writing three tickets and when he unwinds the trade there are three more tickets. That is six tickets and a lot of bid to offer spreads for one idea.
Away from the cynicism it is a means to express a view when one does not necessarily have the deepest conviction. Why is that? The answer is that these trades are highly directional and the middle piece tends to move with the market. So in the example I have been using 2year/5year/30 year spread was as narrow as 53 basis points last week after the announcement of the auction results. That was about the absolute low in prices/high in yield for this little cycle. The 5 year note has rallied approximately 30 basis points and that spread has richened by about 10 basis points. If you were short the 5 year note you would have been stopped out very quickly whereas with the butterfly you are only down 10 basis points if you guessed wrong