Butterfly Trade

June 4th, 2008 12:53 pm | by John Jansen |

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

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  1. 10 Responses to “Butterfly Trade”

  2. By fatbear on Jun 4, 2008 | Reply

    Thanks – now I get it.

    P.S. – Assume “rich” is used as price (not yield) is higher; is “poor” used when price is lower? Or….?

  3. By John Jansen on Jun 4, 2008 | Reply

    Ya lost me there my friend.

  4. By Alejandro on Jun 4, 2008 | Reply

    Hi John,

    I like your blog a lot, I find it very useful.
    Regarding the butterfly, do you think it makes more sense during a steepening or flattening environment? Do you implement it duration neutral o not?
    Thanks a lot and keep doing such a great job.

  5. By fatbear on Jun 4, 2008 | Reply

    You say
    “the 5 year is 141 basis points rich to the Long Bond”
    which means the price is higher (rich) as the yield is lower – right?
    Or does it mean something else?

    And I figured that your use “cheap” not “poor” as in
    “note that the 5 year note is 78 basis points cheap to the 2 year note”
    which means that the price is lower (cheap) as the yield is higher

    Just trying to understand the patois.

  6. By John Jansen on Jun 4, 2008 | Reply

    I had to look up patois. Cool word. i think it is fair to say that all of my comments refer to yield and not price. If you are comparing the 2 year note and the 5 year note the dollar price is meaningless. The meaningful metric is the Yield to Maturity.

    Regarding cheap and poor…….the jargon is rich and cheap….so the 5 year is 78 basis points cheap to the 2year means that the yield is 78 basis points higher. and when i say that it is rich to the long bond by 141 basis points it means that the yield on the 5 year note is 141 basis points lower than the yield on the bond(30 year bond)…hope that makes sense….

  7. By John Jansen on Jun 4, 2008 | Reply

    alejandro……in my experience the trades are always duration neutral…….i have to think about your question on the steepening or flattening environment……

  8. By N N on Jun 5, 2008 | Reply

    Do you have a rule of thumb or equation to convert a treasury future PRICE into YTM?

  9. By george on Jun 6, 2009 | Reply

    u know me as lkofscotland. hope i haven’t offended. also know as does sa haven’t missed a market call in your space yet. that’s what makes me an equity salesman. i watch u first and not cnbc cause i know who the trainwrecker is and that’s the fed and i rates. this time is NOT! different. stop with overthink and let market do what market do (sorry about blackberry speak here) point being this is vietnam war financing all over again. failure to prioritize means save the world. stw means money for nothin, chics for free. avoid debt market like plague. fed will be forced on warpath imminently. if u want stock picks will advise.

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