Which piece do I short and which piece do I long when volatility is expected to be higher than normal? Keep mixing this up
Butterfly with options profits when volatility is low. You highest profit is the middle strike rate (where you sell).
You buy at lower and higher strike rates and sell 2 medium strike rate options.
E.g. buy at x=10 and x=20. Sell two options at x=15. When you profit when your lower call is in the money and the options expire at $15. Your profit would be 15-10 + 2 written calls - call low - call high.
Hope that helps.
Or are you talking about a butterfly twist with yield curves?
If Vol is expected to rise…
Do a short (refers to outer wings) butterfly.
Buy 2 ATM and sell 1 on either side, both OTM.
So I think my logic was correct. Questions asks about decreasing volatility.
Question : trader feels the curve volatility that is priced into the market is too high and would like to profit.
Correct answer is too short the wings which doesn’t make sense bc I thought long wings (increased convexity) outperforms in a stable environment. Keep in mind this is the Boston society mock which overall is trash.
Ok so if rates are expected to be less volatile (stable curve), you can sell convexity to profit as you won’t need it. Therefore, shorting the wings lowers your convexity. You could also sell call options or buy MBS (negative convexity) or callabale Bonds.
^thanks dude