I am trying to understand this concept of how we can combine bullet and barbell positions to exploit a butterfly spread
So according to the book, if you expect the long-term and short-term rates to increase and the medium-term to decrease, you should take accordingly long on the bullet and short on the wings aka barbell, but what I don’t get is why isn’t the other way around?
I mean if we expect the ST and LT to go high, then it means the bond will be cheap to buy
(buy the barbell) and then we can sell it at a higher price when rates go down in the medium term ( sell the bullet). Am I correct in this? Or are we assuming that we already have a position in these 3 bonds and then because we expect the rates to change, we take an active position?
I think you are correct in thinking how the bond prices change with rates, but I believe incorrect in how the trade happens. You can’t wait for the short-term rates to go up (bond price to go down), and then wait 5 years and then sell it - I think that is what you are doing. What is expected is a change in the curve now (or think imminently), so you need to be positioned for that shift.
As I read it, the yield changes are expected to occur soon (in a few days/weeks/months). You buy bonds whose yields you expect to decrease and sell bonds whose yields you expect to increase. When those yield changes occur (in the next few days/weeks/months), then you can unwind these tactical trades and wallow in the profits you made.