Understanding the Significance of Spread Trading In Commodity Futures

Spread trading is actually establishing opposite positions simultaneously in two different contracts. We know that in futures trading there are buy and sell positions. Therefore, it is the creation of buy and sell positions at the same time.

Spread trading is of two types –

1. A) Calendar spread, where the traded contracts belong to the same commodity or asset in the same proportion but of different maturity months. Buying December Jeera and Selling November Jeera is a calendar spread strategy.

2. B) Inter commodity/asset spreads, are between related commodities/assets where opposite positions are taken in different commodities, but of the same expiry, for example buying RM Seed April contract and selling soybean April contract simultaneously.

Calendar spreads provide an opportunity to capitalize any relative miss-pricing between various contracts of the same commodity. Generally, calendar spreads follow a mean reverted process, which means prices tend to move towards the mean. This attribute makes calendar spreads more predictable and range-bound, thereby making trading in spreads easier and less risky than the plain vanilla trading strategy. Studies show that spread price usually moves within a range for a specific time period, and exhibits a reverse movement across the mean.

As the agri futures markets are quite volatile, therefore spread trading is beneficial for the short term/intraday traders or even positional traders/investors due to very low risk. This is because after initiating this trade the risk gets confined to movement of the price differential or spread rather than underlying commodity. The spread trade opportunities usually emerge in NCDEX traded commodities such as Jeera, Soybean, Guar seed, Guar gum, refined soya oil and turmeric usually present spread opportunities almost every month.

The hedgers/positional traders, corporates or speculators who have a long experience in this market, can easily comprehend the seasonal nature for demand and supply of a particular commodity and are able to tap these opportunities on a regular basis. For example in a normal crop year, prices of any agri commodity tend to decline during the harvest period and attain peak levels once the lean season approaches. Under this scenario, one can initiate the spread, buy the contract representing a new crop, and simultaneously sell the contract related to the old crop. The commodity exchanges provide margin benefits for trading in spread. Therefore trading in calendar spreads also enables efficient utilization of the allocated funds.

For creation of the desired spread strategies, it is preferable to have strong analytical ability, thorough knowledge of the historical price trends, seasonality pattern and up-to-date knowledge regarding the demand-supply dynamics of a commodity. Keep browsing this section for further insights on spread trading in agricultural commodities.