I trade direction and slope. But what I really enjoy is trading curvature (for example, butterflies), for a number of reasons:
1) “Concavity.” This is a term I made up – it has some similarities to “convexity.” Look at the 4 year scatter plot of an equal-weighted ED13-17-21 fly on the right (blues on X axis). Note that I exaggerated the close for illustration purposes. Generally, the possible outcomes for a butterfly and a given rate, will not be a linear relationship. History will bear this out, but more importantly, it is so by construction (I may discuss in a future Primer). In the way bond basis traders used to make a small fortune trading the convexity of a bond, you can make a small fortune trading the concavity of ED butterflies. Why take a linear risk (where the payout is 1:1 with the movement of rates) when you can benefit from concavity? And unlike options, there is no cost involved for this benefit.
2) Can provide superior risk/reward. Year flies like the above generally tend to be directional over a certain range. If you were bullish, consider your three main alternatives:
What looks the best? Am I saying you should never trade outright contracts or options? Absolutely not. But many traders do not realize the benefits of a good curvature trade. If you are not trading curvature, you are not making full use of the trading tools available to you!
3) Can provide higher rates of success than other trading styles. I have sat with dozens of directional traders when I was trading at JP. While the “Gold Standard” in prop trading is a 3 to 1 risk/reward ratio, in my observation, most traders failed to be right more than 60% of the time (even factoring in that they may have had bigger winners than losers). Even if your view is right, you can easily get stopped out by volatility. With curvature, you can get success rates above 80%. Just look at the scatter plot on the previous page. I would say there is less than a 10% probability you lose money on that trade. If your assessment is different, I would like to know why. You add up a bunch of 80+% success trades, and that’s going to lead to consistent profitability.
4) Fly trades sometimes have “backstops” – that is, the further a fly trade moves against you, the better it could be (assuming you are not missing a fundamental reason for the continued move against you). This is generally not the case with a directional trade. There may be technical resistance/support levels, but those can dissipate instantly. It is pretty hard for that year fly to get above, say 40. If you think it can get above 40, construct a curve that does, and I’ll tell you what’s exploitable about it and why it couldn’t happen (barring some freak event or positioning).
- Knowing something is highly improbable gives a lot of peace of mind.
- You can make money just knowing where the “backstop” is. I generally advocate leaving room to scale in on most trades. We’ve made money on trades that haven’t moved much, by getting in and out of scales. Lather, rinse, repeat isn’t just for shampoos.
5) Make money like a market-maker. The curve gets kinked all the time because of flows. Market makers have it easier than prop traders – they get a little “edge” from customers. Butterfly “micro trading” captures that little bit of edge from people who are too aggressive in the markets. You wait until they are almost done, or until the curve around that particular point looks too extreme, and take a position the other way. When they want to get out, you make even more money. You would only do this if the position fits your view, but a bp here and there all add up to big bucks at the end of the year – just ask your nearest market-maker.