Buying a spread

A spread is the price gap between two futures contracts on the same commodity, usually two different expiry months. A trader who believes that gap has become wrong can trade the gap itself, rather than betting on which way prices are headed.

Buying a spread means buying the near-month contract and selling the far-month contract at the same time — done when the trader believes the near month is cheap relative to the far month, and expects that mispricing to correct.

This is an intra-commodity spread strategy: both legs are on the same underlying commodity, just different delivery months. The trader buys the near-month contract and sells the far-month contract when the actual spread between them departs from what the trader considers a fair spread — and squares off both legs once the spread has corrected back toward fair value.

The broader rule the workbook gives for spread direction: when the actual spread between two contracts on the same commodity widens, a trader buys the near month (seen as underpriced) and sells the far month (seen as overpriced); when it narrows, the trader does the reverse — sells near, buys far. Buying a spread corresponds to the first case. Such a trade is only reliably profitable when the mispricing comes from genuine market forces, not from seasonal factors like harvest timing, sowing patterns or a quality issue expected in incoming warehouse stock.

A trader believes the gap between June and August gold futures has widened too far — the June contract looks cheap relative to August. She buys one June gold futures contract (1 kg lot) at Rs 71,200 per 10 grams and simultaneously sells one August contract at Rs 71,550 per 10 grams, locking in a spread of Rs 350.

Two weeks later, the spread has narrowed to Rs 180 as she expected: June has moved up to Rs 71,600 and August to Rs 71,780. She squares off both legs — buying back the August short at Rs 71,780 (a loss of Rs 230 per 10 grams) and selling the June long at Rs 71,600 (a gain of Rs 400 per 10 grams) — for a net gain of Rs 170 per 10 gram, or Rs 17,000 on the 1 kg lot. Because both legs move together most of the time, the trade's risk is smaller than an outright directional futures position of the same size.

Chapter 5 (Uses of Commodity Derivatives) sets out buying and selling a spread as a pair, immediately followed by inter-commodity spreads such as crush spread and crack spread, and intra-commodity calendar spreads such as bull and bear spreads. Expect a question on which leg is bought and which sold under "buying a spread" — near month bought, far month sold — and on the condition for the trade to be reliably profitable (genuine market-force mispricing, not seasonal distortion).

• "Buying a spread" means going long the near month and short the far month — not buying both legs. The name refers to the net position in the spread, not a literal double purchase.
• Margins on intra-commodity spreads are lower than on an outright futures position, because the settlement default risk on a spread — where both legs usually move together — is lower.
• A spread trade driven by seasonal factors (harvest timing, sowing season, quality issues) is not the same opportunity as one driven by genuine market mispricing. The workbook explicitly warns that seasonal-driven spreads do not carry the same reliability.