Choosing Bond Butterflies for Mean Reversion, Convexity, or Macro Views

Summary

The document describes several ways to select bonds for a butterfly trade, depending on the rationale for the position. For a relative-value or mean-reversion trade, a trader can assess whether the middle maturity looks unusually rich or cheap against the wings, using regression or principal-component weighting. The example spans both standard curve points and more narrowly spaced maturities.

A different construction targets convexity: a duration-neutral barbell can have greater convexity than a position concentrated in the belly. A butterfly can also express a macroeconomic or central-bank view, such as a forecast that the belly will underperform while the short end remains anchored. These are illustrative trade rationales rather than tested rules; the document gives no quantitative thresholds, risk controls, or evidence that any construction will be profitable.

Key ideas

• Choose butterfly maturities according to whether the trade targets relative value, convexity, or a macro view.
• Regression or principal-component weights can help compare the belly with the wings.
• A duration-neutral barbell may express a long-convexity position.
• A central-bank or growth outlook can motivate a directional butterfly position.
• The examples do not specify entry thresholds or risk-management rules.

Tags

# Various ways to choose bonds for a butterfly strategy?


# Various ways to choose bonds for a butterfly strategy?












What are the various ways to choose bonds for a butterfly strategy? For eg., I already know the most common one i.e., choosing short and long term for the wings (barbell) and the medium term for the body (Bullet).

## Answer by Helin (score 1)

https://quant.stackexchange.com/a/15521

It really depends on what you're trading on.

Very often, butterfly trades are simply mean reverting trades. For example, you may look at 2s/5s/10s (typically on a regression or PCA-weighted basis) and see whether it's trading at "extreme" levels relative to history (i.e., are 5s trading rich or cheap relative to where 2s and 10s are trading). This can be done for any butterflies, as wide as 5s/10s/30s, or as narrow as Feb17s/Aug17s/Feb18s.

Other times, butterfly trades are convexity trades. For example, 5s/10s/30s duration neutral barbell would be a long convexity trade (because 30s are far more convex than either 5s or 10s).

Butterfly trades could also be macro or Fed trades. For example, if you believe the fed will keep the front end of the curve anchored in the near term, but future growth outlook is improving very dramatically, causing the belly of the curve to underperform, then shorting a 2s/5s/10s butterfly would make a lot of sense (this kind of trades worked very well this year).

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.