Trading commodity derivatives is more complex than trading equity derivatives. This is because commodity is a physical asset and is, therefore, driven by supply. Of course, equity derivative also has a supply constraint, as the NSE caps the maximum number of contracts that can be traded in any month through the market wide position limit. Nevertheless, the more realistic supply-side constraint on commodity derivatives allows traders to initiate innovative calendar strategies on an underlying commodity. This week, we explore whether a calendar strategy can work with equity index and single-stock futures.

Relative pricing

In options trading, a long calendar call spread on the Nifty Index would involve buying the next-week call and shorting the near-week call of the same strike. The objective is to profit from volatility explosion you expect to take place in the next-week call after the near-week call expires. This could be because of an event that is likely to take place the next week, say, the Union Budget.

The motivation is different if you want to use futures. In such cases, you must use the near-month and the next-month contract. With the Nifty Index currently trading at 22451, the near-month futures trades at 22528 and the next-month at 22679. Conceptually, the next-month contract must trade at a higher price than the near-month contract because of the interest factor.

That said, the actual futures price may be different from the theoretical price for two reasons. One, the futures valuation model does not consider mark-to-market margin. And two, the demand for the contract can push the price away from theoretical price. In addition, the next-month futures price may be more disconnected from the spot index than the near-month futures price because the latter is more actively traded than the former. For instance, the near-month contract had almost 10 times the volume compared to the next-month contract. Also, the near-month contract has a narrower bid-ask spread than the next-month contract.

Combine the above observation with the fact that futures price must converge with the spot price at expiry, and you can translate this into a strategy. If you believe that the next-month contract is overpriced relative to the near-month contract, then you must go long on the near-month futures contract and short the next-month contract. The March contract at expiry will converge with the spot index whereas the April contract will trade closer to the spot index than today. Your gains will be the price difference between the two futures contract at March expiry less the price difference when you setup the strategy.

Note for traders
If you believe that the next-month contract is overpriced relative to the near-month contract, then you must go long on the near-month futures contract and short the next-month contract
Optional reading

The strategy must be initiated only if you believe that the next-month contract has a higher implied rate than the near-month contract, which you can determine by substituting the actual futures price in the futures valuation model. Also, the position must be closed on the expiry of the near-month contract. Note that the position benefits from cross margins.

The author offers training programmes for individuals to manage their personal investments

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