In addition to trading the slope of the curve, there's another type of yield curve trading strategy that focuses not on the slope, but on the curvature of the yield curve. These strategies are often called butterflies or curvature trades. What is a butterfly trade? A butterfly trade expresses the view that a particular maturity or segment of the curve, usually in the belly or middle of the curve, is mispriced relative to shorter and longer term maturities. The trade consequently combines a long position in one maturity. The body with short positions in two other maturities the wings or vice versa. If an investor believes the yield in the belly of the curve, the body is too high relative to the wings, they would take a long position in the belly and short positions in the wings. On the other hand, if the investor believes the yield in the belly is too low, they would do the reverse short the body and go long on the wings.
The most common butterfly trade is the 50 50 weighted butterfly, which is constructed to be duration neutral. This means it has zero overall duration and equal duration values on each wing. Minimizing exposure to parallel shifts in the curve, just like steepener and flattener trades. In a 50 50 butterfly, the fly spread or the metric that the trade profits from, is calculated as two times the yield of the body, minus the yield of the shorter tenor wing and minus the yield of the longer tenor wing.
If this difference widens or narrows, as the investor expects, the trade becomes profitable.
Let's consider an example of a butterfly trade where the investor expects the yield in the belly to fall relative to the wings. They would take a long position in the belly and short positions in the wings. If their view plays out and the yield of the belly decreases relative to the wings, the trade will become profitable. You can see this concept illustrated on the screen. The today curve represents the current yield curve. While the expected curve represents the investor's view that the belly of the curve will fall relative to the short and long ends.
