Futures bull spread

Take two futures contracts on the same commodity with different delivery months. The gap between their prices is the spread.

That gap has a normal size. The workbook calls it the fundamental spread, or the average difference between the two calendar months.

Sometimes the actual gap is wider than normal. A trader who expects it to come back to normal can trade the gap itself.

That trade is a futures bull spread. Buy the near month. Sell the far month. Then wait for the gap to narrow.

Notice what is not being predicted. The trader has no view on whether gold rises or falls. He has a view on the distance between two gold contracts.

The workbook's other name for exactly this trade is buying a spread. And do not mix it up with the option bull spread on the vertical spread page. Same adjective, different instrument.

The trigger. A bull spread using futures is created when the actual spread is more than the fundamental spread — the average difference — between two calendar month contracts. The expectation on creating it is that the difference will narrow.

The legs. Buy the near-month futures contract; sell the far-month futures contract. This is an intra-commodity spread, also called a calendar spread: a long position in one month and a short position in another month of the same underlying, or in another contract of the same commodity with a different lot size.

The steps the workbook sets out. Step 1, buy near and sell far. Step 2, hold and watch the spread daily. Step 3, square off by closing out both futures contracts once the spread has moved.

Why the margin is lower. The level of settlement default risk on such a position is low, so margins are low. SEBI's circular of March 2023 on spread margin benefit gives relief of up to 75% of total initial margin where both legs are on the same underlying commodity, and up to 50% across two different commodities in a commodity complex, the latter requiring a correlation of 0.90 between the two. Extreme Loss Margin still applies individually to both legs, and the benefit is available only where each contract in the spread is among the first six expiring contracts. See spread margin benefit.

When it does not work. The workbook is blunt that a spread trade is reliably profitable only if the misalignment comes from market forces. A gap caused by harvesting season, sowing season, crop failure, or a quality issue with a crop expected into the warehouses is not the same opportunity, because the gap may be correct rather than wrong.

The workbook's own gold calendar spread. A trader expects the April-to-June gap to squeeze, because buy-sell pressure in the near month is skewed while the next month is normal.

Step by step. He buys April at Rs 50,100 and sells June at Rs 50,200. On the 20th the spread has narrowed sharply to Rs 60, so he squares off. The April long gained Rs 160 per 10 grams; the June short lost Rs 120 per 10 grams. The net is Rs 40 per 10 grams, and it is exactly the Rs 100 to Rs 60 collapse in the spread.

Now put it in rupees per lot. Gold is quoted per 10 grams and the contract lot is 1 kilogram, which is 100 quotation units:

Rs 40 x 100 = Rs 4,000 net gain on a one-lot spread.

Read the table again and notice what did not happen. Gold rose on both legs over the twenty days. A trader who had simply gone long April would have made Rs 160 per 10 grams, four times as much. The spread trader accepted that smaller number in exchange for being indifferent to the direction of gold — and would still have made his Rs 40 if both contracts had fallen by Rs 500, so long as the gap closed from 100 to 60.

Chapter 5 (Uses of Commodity Derivatives), section 5.5 on spread trading, under the heading for intra-commodity or calendar spreads, where bull and bear futures spreads are defined and worked as a pair.

The reliable question is the fill-in-the-blank on the trigger: a bull spread using futures is created when the actual spread is ____ than the fundamental spread — more — and the expectation is that the difference will ____ — narrow. A calculation question built on the workbook's own table, ending at a net gain of Rs 40, is equally standard. The discriminating question pits the futures bull spread against the option bull spread of section 5.7.2, which is a completely different construction.

• Actual spread MORE than fundamental, expected to NARROW. Two halves, and reversing either one turns it into a futures bear spread.
• Buy near, sell far. The bear spread does the opposite. Getting the legs backwards inverts every figure that follows.
• A futures bull spread is not an option bull spread. The option version buys the lower strike and sells the higher strike of the same expiry — see vertical spread. No strike prices appear anywhere in the futures version.
• The profit is the change in the spread, not the change in either price. In the workbook's table gold rose on both legs and the trade still returned only Rs 40 per 10 grams.
• Bull does not mean bullish on the commodity. It means bullish on the near month relative to the far month.
• This is the same trade the workbook elsewhere calls buying a spread. One trade, two names, taught in two places in the same chapter — expect either wording in a question.
• Margin relief is conditional, not automatic. Both legs must be among the first six expiring contracts, and Extreme Loss Margin is charged on each leg separately.
• A spread caused by seasonality — harvest, sowing, crop failure, an expected warehouse quality issue — is not a mispricing. The workbook says the strategy is reliably profitable only when market forces caused the gap.