Butterfly Trades Question

agree with Martin...and to add a bit of color (assuming you are looking at US interest rates)...first, there are micro and macro flies. Micro would be something like 5yr-6yr-7yr fly. or EDH9-EDM9-EDU9 (usually guys trying to fade a specific flow in a security that quickly creates a kink in the curve) Macro would be 5yr-10yr-30yr....or even 10yr-20yr-30yr...things with lots of duration inbetween the legs.

With the micro butterflies, you would usually use 50/50 DV01 weights on the wings...but with the macro flies, you will often find that the fly movement is usually dominated by one of the wings in certain market environments.

Environment right now is composed of a few things 1) fed rate hikes, and the timing of market expectations 2) trump tax policy effects (increased debt issuance, etc..) 3) asset allocation (with the stock market making record highs, you would expect a rebalance into the long end) 4) etc...

some of these things have conflicting effects...others magnify...but for each, the market is telling a story...and its your job to understand the story (so you can find / anticipate the turning points)

so, if we dive in and look at the 5yr-10yr-30yr fly...the natural place to start is the 50/50 fly.

short 50k DV01 5yr long 100k DV01 10yr short 50k DV01 30yr

so, if the market rallies 10 bps in parallel, you will make 1mm on the long 10yr, and lose 500k in both the short 5yr and short 30yr positions. This is the "neutral" butterfly.

But what if when the market rallies, its not in parallel...what if the rally has to do with insurance and pension fund investments...but has nothing to do with anticipated Fed rate hikes...the front end out to the 5yr probably won't move much...but the 30yr will move A LOT. In this scenario, the 30yr wing will outperform, and this 5-10-30 fly will have real PnL driven mostly by the 30yr leg. In the reverse, if the market is at an inflection point regarding fed rate cuts/hikes...then the front end will be the primary mover. So this is why you might use PCA weightings to neutralize those effects. When trading a butterfly, you are trying to capture the richness or cheapness of the belly, given the backdrop of the environment...and so you might have to change the wing weights...for example, instead of 50/50, you might use 70/30...or whatever you find in your analysis to be the most stable given the environment.

Now, lets move to cash neutral. This is something that real money accounts like pension funds use to express a view on the market, and a couple other things. A pension fund might go long 100mm 5yr notes short 200mm 10yr notes long 100mm 30yr bonds

This position will behave essentially just "long the 5yr notes" because 100mm 30yr bonds is about DV01 equal to 200mm 10yr notes. Why would they do this? Maybe that have a mandate to be cash neutral? There are lots of reasons. Maybe they want the 10/30 flattener ad to be long the 5yr and they track that portfolio? Anyway..just realize that these are very different things.

Regression is shortcode for "liner regression" (traders are lazy) You use a regression to find the PCA weights.