Selling a spread

A spread trader does not bet on where a commodity's price is going. He bets on whether the gap between two contract months on the same commodity is too wide or too narrow, and trades that gap directly.

Selling a spread is one half of that trade. It means selling the near-month contract and buying the far-month contract at the same time — the mirror image of buying a spread, which does the opposite.

The workbook is precise about when this strategy is used: a trader sells a spread when the near-month contract is overpriced or the far-month contract is underpriced relative to each other. He sells the near month and buys the far month, and squares off both legs once the spread corrects back to what he considers a fair level.

This is the reverse of buying a spread, which is used when the near month looks underpriced relative to the far month instead. Both are intra-commodity spreads — trades within the same commodity across different expiries — and both qualify for the spread margin benefit, which can cut required margin by up to 75 per cent compared with margining the two legs on their own, since the legs tend to move together.

In April, Mr Y believes gold's June futures contract is overpriced relative to its August futures contract. He sells one contract (1 kg) of gold June futures at Rs 50,750 per 10 gm and simultaneously buys one contract of gold August futures at Rs 50,800 per 10 gm.

As he expected, the spread widens through May. He squares off both legs: he buys back June futures at Rs 50,800 per 10 gm and sells August futures at Rs 50,900 per 10 gm.

June leg: sold at 50,750, bought back at 50,800 -> loss of Rs 50 per 10 gm
August leg: bought at 50,800, sold at 50,900 -> gain of Rs 100 per 10 gm
Net gain = Rs 100 - Rs 50 = Rs 50 per 10 gm

On a 1 kg (100 x 10 gm) lot, that is a net gain of Rs 5,000 — made entirely from the change in the spread, regardless of which direction gold's outright price moved.

Chapter 5 (Uses of Commodity Derivatives), section 5.5, on spread trading, immediately after the workbook's worked example of buying a spread. Expect a scenario question asking whether a given view on near-versus-far pricing calls for buying or selling the spread, and a profit calculation across both legs.

• "Selling a spread" is not the same as simply selling a futures contract. It always has two legs — a sale and a purchase, on different expiries of the same commodity.
• The trigger is a relative mispricing between near and far months, not a view on the outright commodity price.
• Sell the near month and buy the far month when the near month looks overpriced — reversing which leg is bought and which is sold is the most common error in this topic.