A butterfly is a trading strategy that, under certain circumstances, reduces the volatility of your bond portfolio's value. To understand a fixed-income butterfly strategy, think of a teeter-totter. One side goes up the same amount as the other goes down, and the center remains fixed in place. The wings of the butterfly strategy are the two ends and the "bullet" is the center fulcrum. A butterfly spread neutralizes some yield curve movements.
Bonds of Equal Credit Quality
United States Treasury securities are most commonly used as the basis for fixed-income trading strategies like the butterfly because they represent a huge, liquid market sector that has the same credit rating throughout. Corporate bonds have different credit ratings and trade according to those ratings. All bonds trade based on the market level of interest rates, changes in the yield curve, supply and demand, and credit ratings. However, Treasuries are not affected by credit considerations because they all carry the good faith and credit of the United States, and are all rated the same. Since a butterfly involves selling the bullet short, recently-issued Treasuries are the only bonds that can be reliably shorted.
Duration and Convexity
Longer bond maturities fluctuate more in value for a given change in the short end of the yield curve. If interest rates rise one percentage point -- from 1 percent to 2 percent, for example -- in the short maturities, the longer maturities will react with a correspondingly greater movement. This is called duration. In simple terms, the longer the maturity, the higher the duration is likely to be. Other factors -- such as coupon rate, market demand and the way the formula for yield-to-maturity takes into account interest payments -- have effects on the way the values of bonds along the yield curve maturity scale perform relative to a move in rates. This is called convexity. A butterfly spread uses duration and convexity to counteract or take advantage of changes in the shape of the yield curve.
The Yield Curve
The yield curve fluctuates in daily trading and changes shape. When it is flat, the spread between long-maturity yields and short-maturity yields is relatively narrow. This usually happens when the perception of risk is high for the next few months. A flight-to-quality will also temporarily change the shape of the yield curve as money moves out of foreign countries or the stock market to the safety of bonds. A normal yield curve slopes upward from short to long maturities. A butterfly spread takes advantage of the fluctuation of interest rates relative to each other along the yield curve. Because of the effects of duration and convexity, the yield curve has a hump that occasionally changes place along the curve in the intermediate range from 5- to 20-year maturities.
The Butterfly Strategy
A simple butterfly position involves selling short an intermediate-maturity bond (the bullet), such as the 10-year Treasury, and buying a short-maturity bond like the 5-year and a long-maturity bond like the 30-year (the wings). You can also use different maturities, such as going long on the 4-year and 8-year maturities and shorting the 6-year maturity. This is an advanced trading strategy, so enlist the advice of a broker experienced in this type of trading before you attempt it yourself. There are formulas to measure the duration and convexity of the bonds and place your wings and bullet where you expect the most fluctuation in the yield curve. When attempting to trade using butterfly strategies, keep in mind that they don't necessarily work as you expect and sometimes have to be adjusted by changing your position in one or all of the three bonds involved.
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