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Last Updated : Jul 22, 2017 01:45 PM IST | Source: Moneycontrol.com

Want to strike a profitable trade? Here’s how you can do with ‘Calendar Spreads’

An arbitrage opportunity is created when you can buy something for cheap in one market and sell the same in a market where the price is higher.


Karthik Rangappa 

An arbitrage opportunity is created when you can buy something for cheap in one market and sell the same in a market where the price is higher.

For example - you can buy apples in Kashmir for Rs 100/kg and sell the same in Bangalore for maybe Rs 250/kg.

Close

The assumption here is that Rs 150 in profits covers up for the transportation and other charges. This works out to be a profitable strategy without involving any risk.

Of course, the assumption here is that there are always sellers in Kashmir and buyers in Bangalore. The calendar spread is a simple arbitrage strategy that you can follow in equity markets.

In a calendar spread, we attempt to extract and profit from the spread (the difference between buying and selling price) created between two futures contracts of the same underlying instrument but with different expiries.

Here is an example -

Wipro Spot is trading at = 653

Current month futures fair value (30 days to expiry) = 658

Actual market value of current month futures = 700

Actual market value of mid month futures = 665

Mid month futures fair value (65 days to expiry) = 663

From the above example, clearly, the current month futures contract is trading way above its expected theoretical fair value.

However, the mid-month contract is trading close to its actual fair value estimate. With these observations, we will make an assumption that the current month contract’s basis ( the difference between spot and future) will eventually narrow down and the mid-month contract will continue to trade close to its fair value.

Further, with respect to the mid-month contract, the current month contract appears to be expensive. Hence, we sell the expensive contract and buy the relatively cheaper one.

Therefore, the trade set-up would require me to buy the mid-month futures contract @ 665 and sell the current month contract @ 700.

The spread, as we know, is the difference between the two future contracts i.e 700 – 665 = 35 points.

The trade set-up to capture the spread goes like this –

Sell the current month futures @700

Buy the mid-month futures @665

Do note – because you are buying and selling the same underlying futures of different expiries, the margins are greatly reduced as this is a hedged position.

Now, after initiating the trade, one has to wait for the current month’s futures to expire.

Upon expiry, we know the current month futures and the spot will converge to a single price. Of course, on a more practical note, it makes sense to unwind the trade just before the expiry.

Let us arbitrarily take a few scenarios as below and see how the P&L pans out –

Expiry

Do recall the critical assumption we have made here is that i.e. the mid-month contract will stick close to its fair value. As long as this assumption holds, the Net P&L should close at over 35.

(Disclaimer: The author is VP, Educational Services, Zerodha. The views and investment tips expressed by investment experts on Moneycontrol are their own and not that of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.)

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First Published on Jul 22, 2017 10:19 am
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