Butterfly Curve Trades

A classic butterfly picks three points on the curve, say 2-year, 5-year, and 10-year Treasuries, and takes offsetting positions: long (or short) the "belly" (5-year), against an opposite, duration-weighted position split between the "wings" (2-year and 10-year). The weights are chosen so the trade has zero net duration and is neutral to a simple steepening or flattening of the curve; what it actually expresses a view on is curvature, whether the belly is unusually rich (yielding too little) or cheap (yielding too much) relative to a straight line drawn between the wings.

Concretely, a "long the belly" butterfly buys the 5-year and sells duration-matched amounts of 2-year and 10-year, profiting if the 5-year yield falls relative to the wing-implied level even while the general level of rates moves around unpredictably, for instance if the 5-year rallies 15bp while the wings only rally 5bp each, the butterfly gains on the mismatch even though all three yields fell together. Traders use these to express a pure view on curve shape, or to fade a distortion caused by heavy issuance or forced selling concentrated at one maturity. Because the wing weights must be recalculated whenever yields or durations shift meaningfully, a butterfly that starts perfectly duration-neutral can drift away from neutrality as the position ages, so desks typically rebalance the wing weights periodically rather than setting them once and holding to maturity.