Calendar strategy with futures

Gains will be the price difference between the two futures contract

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 supplyside 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 singlestock futures.

RELATIVE PRICING

In options trading, a long calendar call spread on the Nifty Index would involve buying the nextweek call and shorting the nearweek call of the same strike. The objective is to profit from volatility explosion you expect to take place in the nextweek call after the nearweek 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 nearmonth and the nextmonth contract. With the Nifty Index currently trading at 22451, the nearmonth futures trades at 22528 and the nextmonth at 22679. Conceptually, the nextmonth contract must trade at a higher price than the nearmonth 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 marktomarket margin. And two, the demand for the contract can push the price away from theoretical price. In addition, the nextmonth futures price may be more disconnected from the spot in

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

dex than the nearmonth futures price because the latter is more actively traded than the former. For instance, the nearmonth contract had almost 10 times the volume compared to the nextmonth contract. Also, the nearmonth contract has a narrower bidask spread than the nextmonth 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 nextmonth contract is overpriced relative to the nearmonth contract, then you must go long on the nearmonth futures contract and short the nextmonth 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.

OPTIONAL READING

The strategy must be initiated only if you believe that the nextmonth contract has a higher implied rate than the nearmonth 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 nearmonth contract. Note that the position benefits from cross margins.