In my previous article, I highlighted the buy or sell spread trades, which could be described as intra-market or calendar spreads, as they involve buying a futures contract in one month while simultaneously selling the same contract in a different month.
To recap, the goal of this strategy is to take advantage of the relationship between the two contracts. In most cases, there will be a loss in one leg of the spread, but a profit in another leg.
If the calendar spread is successful, the gain in the profitable leg will outweigh the loss in the losing leg. A closely related strategy is the Intermarket spread, which involves buying and selling two different but related futures with the same contract month.
An example is buying KCB September futures and selling September Equity futures if you think the latter is overextended to the top. But we won’t get into that today as I’d first want to highlight the merits and demerits of spreading.
To start with the benefits, first, the trade as a whole has less risk considering the direction of the particular futures prices.
In contrast, an unhedged position is at risk from changes in the price of the contract held. Investors holding underlying shares can also use the strategy to hedge against losses as their cash position is mirrored by an opposite position in the futures market. Second, by shorting one contract and being long another, the trader can reduce his/her overall net position and hence allow for greater positions on the exchange without hitting position limits.
Even if position limits are reached, by being short one contract and long another contract, a trader will have a better argument of why they have such large positions (i.e., the position is naturally hedged).
Third, putting on a spread trade means that the actual margin requirements from NSEs are lower allowing greater leverage possibilities. Let's use an actual example, the outright margin for September KCB futures is Sh4,600 and the outright margin for September Equity futures is Sh5,800.
Rather than posting Sh10,400 (4,600 + 5,800) to trade a spread on these two contracts, a trader may receive a 75 percent margin credit; in other words, the initial margin would be Sh2,600 (25 percent x 10,400), which reflects the lower risk in spreading the two contacts as opposed to trading each of them upright
Disadvantages. First, with futures, leverage is employed. By now you know, too much of it is dangerous, need I say more? Second, the effect of trading costs (commissions, fees, bids and spreads, etc) may make most spreading opportunities unprofitable if they outweigh any targeted profits. Lastly, traders also need to monitor liquidity, as it may be difficult to exit a trade at an attractive price if there is insufficient interest among potential buyers.
Warning: some of the NSE contracts are notoriously illiquid. Additional note: NSE's derivatives rules do not allow net long/short positions separately or in combination beyond set position limits. However, exceptions apply only on genuine hedging or spread positions between single months of a futures contract.
Mwanyasi is MD, Canaan Capital.
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