Traders typically prefer near-month futures contracts for several reasons, one of which is better liquidity. Of course, it could well be that near-month contracts are liquid because traders prefer them. This week, we discuss when it is optimal to consider the middle-month futures contracts.

Directional bias

Liquidity impacts pricing. Because of greater demand, near-month contracts are more aligned to the spot price of the underlying than middle-month contracts. The bid-ask spreads are also better. At the time of writing this article, the near-month Nifty futures contract had a bid-ask spread of two points, whereas the middle-month contract had four points. Pricing is important for trading profits. Therefore, liquidity becomes an important factor for trading. So, most of the time, you ought to prefer near-month contracts.

There are two occasions when you could consider the middle-month contract, especially on Nifty futures. The first is a hedged trade. This involves trading both the near-month and the middle-month contracts. The objective here is to profit from a directional bias with minimal risk. This trade has its base in the valuation model which considers futures value as the underlying’s spot price times the cost of carry. That is, the interest on the spot price till the expiry of the futures contract is factored into the futures value. The logic is that payment for the futures contract is required only at expiry. So, that amount can earn interest for you until expiry. Therefore, the interest cost is added to the spot price to make it level playing for both the buyer and the seller. Otherwise, the buyer would prefer futures contract, whereas the seller would prefer the spot market, where payment is received based on a much shorter settlement cycle.

The rule for hedged trade is simple. You must determine your directional bias. For instance, is there a greater possibility of the Nifty Index going up than coming down? You should go long on the near-month and short on the middle-month contract if you have an upside bias. If you have a downside bias, you should short the near-month and go long on the middle-month contract. Why? When the spot index moves up, the near-month contract could move more relative to the middle-month contract. Likewise, if the spot index declines, the near-month contract could fall more than the middle-month contract. Note that your gain on this trade is restricted to the price difference on both contracts; you could trade several contracts to increase your expected gains. Note also that this trade is meaningful when you do not have a strong conviction on the directional movement. A price break-out or a break-down, for instance.

Take note
An arbitrage trade involves the near-month and the middle-month contracts, but is set up to exploit relative mispricing

The second trade, though atypical, is when you have a strong directional view, and the middle-month contract is cheaper than the near-month. This does not mean that middle-month has a lower price, but that the implied interest rate based on the futures valuation model is lower for the middle-month compared to the near-month contract. Importantly, this trade is optimal only if you expect the underlying to move gradually to your target price beyond the near-month expiry.

Optional reading

There is a subtle difference between the hedged trade and an arbitrage trade. The latter also involves the near-month and the middle-month contracts, but is set up to exploit relative mispricing. That is, you first determine the implied rate on the near-month and the middle-month contracts. You then go long on the contract that has the lower implied rate and short on the one that has the higher implied rate. You are betting on the market correcting this mispricing.

So, sometimes, you may have to go long on the next-month contract and short on the near-month contract. And if the index moves up, it is moot if the market will correct such mispricing, given that near-month contract has greater demand than the middle-month.

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