A trading technique involving the buying of a derivative of an asset in one month and selling a derivative of the same asset in another month
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What is a Calendar Spread?
A calendar spread is a trading technique that involves the buying of a derivative of an asset in one month and selling a derivative of the same asset in another month. It is most commonly done in the case of futures contracts in commodity markets, especially for grains such as wheat, corn, rice, etc. Futures trading is a very volatile activity, as most prices are affected due to multiple external macroeconomic conditions that cannot be controlled.
In most cases, the currency of a country is tied to the value of commodities it exports. In spread trading, the market prices of the commodities exert little effect on the profit made by investors. It is because there are two different legs of the trade, buying a contract and selling another one.
Therefore, profitability lies in the relationship between the two spreads. An investor may make money in one leg of the deal and lose money in the other. A successful spread is one where the profit from one leg outweighs the loss from the other, hence turning an overall profit for the investor.
Summary
- A calendar spread is a trading technique that involves the buying of a derivative of an asset in one month and selling a derivative of the same asset in another month.
- Futures trading is a very volatile activity, as most prices are affected due to multiple external macroeconomic conditions that cannot be controlled.
- A successful spread is one where the profit from one leg outweighs the loss from the other, hence turning an overall profit for the investor.
Cost of Carry
The difference between the futures contracts of the same commodity withiin a two-month period is known as the cost of carry. It includes the cost of holding the commodity for the time period between the two months in question. Literally, it is the cost of “carrying” the commodity for a specified period of time. It includes financial costs such as interest on loans taken, insurance, storage costs, and the opportunity cost associated with choosing one position over another.
The price difference between two contract positions is monitored in future spread charts. It helps investors in handling the margins of trading in a particular grain. Monitoring future spreads is also useful to predict the future price directions of commodities as the positions can give hints of future scarcity or surplus (due to bumper crops).
Contango and Backwardation
Trading in spreads allows investors to reduce the risk involved, as trades are mostly affected only by supply and demand factors. In months when supply is sufficient to fulfill demand, deferred contracts are more expensive than nearby months. Such a situation, when the price as per the futures contract (future’s price) is higher than the sport price or real market value of the good on the delivery date, is known as contango or forwardation.
Conversely, when the commodity is traded at a price lower than its spot price, the market is said to be in backwardation. Nearby months are the months in which the futures contract is set to expire or the month in which the delivery date lies. Deferred months are the later part of the same. The two different types of spread positions are as follows:
- Bull spread: When a trader buys the nearby month and sells the deferred month.
- Bear spread: When a trader sells the nearby month and buys the deferred month. It happens in cases of anticipated market volatility. Price swings are always higher in nearby months and tend to get stabilized around deferred months.
Other Types of Spreads
In grain markets, there are three major types of spreads:
- Intra-market spreads/Calendar spreads: Buying a futures contract for a certain grain in one month and selling another contract for the same grain in a different month.
- Inter-market spreads: Buying and selling futures contracts of related grains simultaneously. For example, corn and soybean are related commodities, and the ratio of their prices is taken into account while deciding to trade.
- Commodity-product spreads: Buying and selling futures for raw commodities and processed commodities (using the same raw commodity), respectively. For example, if soybean is the commodity, soy milk is the product.
More Resources
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