Quoting: The convention in the pit is to quote a butterfly based on what is done to the first contract. So buying the “EDM6 6 month butterfly” would be buying 1 EDM6, selling 2 EDZ6 and buying 1 EDM7.
To Weight or Not to Weight: You can think of a butterfly as two spreads: In our example, selling the ED13-17 year spread and buying the ED17-21 year spread. I prefer to do equal-weighted butterflies – so we would be working with the same quantities of the ED13-17 spread and the ED17-21 spread. These are easier to trade, since: (1) it is easier for the locals to make and maintain a market and (2) you can trade equal-weighted butterflies as a structure on Globex. But there may be times when a weighted fly is more appropriate. You could sell slightly less of the ED13-17 year spread to create a trade that would make a little less money on a rally and a little more on a selloff – basically creating a more “direction-neutral” trade. If this is your preferred way of looking at butterflies, I can help you with weightings. However, weightings will vary based on your choice of the historical comparison period (which can be tricky), weightings can change over time, and it takes a little more work to manage a book of weighted butterflies. Many times, I will prefer to just do another counterbalancing butterfly. In the example above, we could add a bearish-leaning butterfly (see double butterflies below).
Structures: The most common compound butterfly structures used in the Curve Advisor are:
- “Regular” Double Butterfly – if one is good, then two must be better! To be honest, not always. But many times, buying one butterfly vs selling another butterfly can provide a good look on both a rally and a selloff. Typically, I will notate this as “buy EDM6 6mo fly vs sell EDZ6 6mo fly,” or “buy M6-Z6 6mo double.” This will be: (buying 1 EDM6, selling 2 EDZ6, buying 1 EDM7) and (selling 1 EDZ6, buying 2 EDM7, selling 1 EDZ7). You can combine the contents of the two parentheses to get: (buying 1 EDM6, selling 3 EDZ6, buying 3 EDM7, sell 1 EDZ7). In this case, there was overlap in the back spread of the first fly and the front spread of the second fly. This allows the broker the option of executing as a 1×3 – that is, they can buy 1 EDM6-Z7 spread vs sell 3 EDZ6-M7 spreads.
- Other Double Butterflies – The butterflies we buy and sell do not have to be overlapping. A common structure is a 6 month double butterfly that is 1 year apart (rather than 6 months apart). For example, “buy EDM6 6 mo fly vs sell EDM7 6mo fly,” or “buy M6-M7 6mo double” (buy 1 EDM6, sell 2 EDZ6, buy 2 EDZ7, sell 1 EDM8). This structure has the benefit of only having six legs (instead of eight), and can be traded as one EDM6-M8 spread vs two EDZ6-Z7 spreads (or you can always do fly to fly if that is more liquid).
- “Arb” (aka a double double butterfly) – There may be a point on the curve that is extremely mispriced relative to the surrounding contracts. You could do a double butterfly around the point, but sometimes, it is better to attack the point from both sides. For example, ArbM6 would be “buy M5-Z5 6mo double and sell Z5-M6 6mo double.” This structure is most easily traded as buy 1x M5 year fly vs sell 4x Z5 6mo fly.
- I sometimes like to get creative, so you may see me putting something out, like “Buy 1x EDM5 6mo fly vs sell 2x EDZ5 6mo fly.” If you are ever unsure of what I am suggesting, just send me (or your broker) an email.
Plots and Graphs. There are two main graphics I will use in the CA:
- The first is a “scatter plot” (see page 1) to show a historical relationship. The y-axis has the structure price and the x-axis has the level of the blue pack. I have plotted 4 years’ worth of data. The black dot is the previous day’s close. This plot will show the historical relationship of the structure to the change in rates. It will also show how far above or below the current point is to the historical “fitted line.”
- The second is a graph of the similar structures centered around each contract from the most recent days’ close. The y-axis shows the number of basis points and the x-axis shows the contract the structure is centered around. In this example, the blue line shows the closes of all the 6 month flies, starting with the first. Since the first 6 month fly is centered around the third contract, it is shown where x=3.
Contract Expiry Adjustment. I prefer to look at constant-maturity eurodollars. If we are 2 months from contract expiration, when I do my historical comparisons, I compare today’s point to all points that were the same number of days to expiry. Comparing apples to apples is more important as we get closer to the front of the curve.
Year-End Turn Adjustment: There historically has been a year-end turn priced into the Z contracts. When I first started trading, it was about 6bps (so you needed to add 6bps to the EDZs to “smooth” out the curve). Nowadays, there is almost zero priced into the first three years and between 0.5 and 0.75 bps after that. You need to make sure you adjust for this when looking at butterflies, since the effect could be magnified. Some structures, like a 6 month double fly, can have as many as 4 turns. The turn is especially important when comparing historical data because four years ago, the turn was closer to 2bps. Your plots and graphs will look like jibberish if you do not adjust correctly. That is why for relevant trades, I will note what the “turn-adjusted” level of a trade is (I may abbreviate as “TA”). My scatter plots and graphs will almost always show the turn-adjusted values, rather than the actual prices.
Rolldown (and Rollup). One of the considerations of any trade is how well it rolls down (or up) the curve. You generally want structures that will make money (or not lose much money) if the staus quo is maintained – sometimes people refer to this as “carry.” “Rollup” is the term I use to designate what happens when the timetable for rate hikes is moved forward, but the shape of the (fly) curve remains the same. Keep in mind that the shape of the curve can sometimes change and what was once a positive rolldown (or rollup) situation can become a negative one.
Getting Fills: You have to be patient. It could take days, or even weeks to get your desired fills. Many butterfly markets are ½ bp wide (like most things in the Merc). Because we may be looking for as little as 3-5 bps, it pays to be patient rather than just hitting the bid and lifting the offer. Hitting the bid and lifting the offer every time could be 25% of your total profit. But it’s not your time! That’s why you have your CA broker – feel free to “waste” their time. They are more than glad to do it. If something is extremely attractive, I may say to work with a tic (to get your base size on) and scale in above.
Scaling: I think of butterfly pricing like a rubber band. The further it is stretched, the more it has to move and the more attractive it is. So I like scaling into and out of trades. When I see “value” on the curve, I like getting on only 25-50% of my total size. If it makes money, great. If it loses money, most of the time that will be even better! If I think you should get on 80+% of your full position at the current market levels, I may say something like “back up the truck.”