Calendar Spreads: A easy guise for Profitable Trading

Calendar Spreads

The classic approach

Here’s a quick recap on how traditional calendar spreads are dealt with a price based approach- 

Determine the reasonable worth of the current month agreement.

Estimate the just price of the mid-month contract.

Look for relative mispricing between the two contracts

You can execute a Calendar Spread by either purchasing the current month contract and then selling the mid-month contract or alternatively, selling the current month contract and buying the mid-month one. An instance of this type of arrangement is demonstrated below:

Purchase TCS Futures expiring on June 28th, 2018 at a price of 1846.

Invest in TCS Futures expiring 28th July 2018 @ 1851.

Here you can purchase and sell futures of the same stock but with contracts having different expiries, as shown above. The gap between prices of the two contracts is what is usually tapped into in these trades. Since risk levels are quite low in calendar spreads, profits made off them may also be meager. If you’re like me who would prefer to steer clear of larger risks, then this may just be your thing!

This strategy for executing a calendar spread is viable.

If you haven’t been exposed to this concept before, I’d recommend glancing through Chapter 10 of the Futures Trading module. It provides a fundamental overview of the classic calendar spreads process and serves as a base on which to expand your knowledge of its alternate forms.

Let’s begin right away.

– Calendar spread logic

Having gone through the pair trading segments, it should be relatively simple to comprehend the calendar spread concept. This uncomplicated strategy supposes that present market prices are determined by all available info relevant to the stock, ranging from news, corporate transactions, discounts/mark-ups and fair value assessments.

Assuming the proposed assumption is valid, we may be able to use the price itself as an indicator to identify potential calendar spread trades. This significantly simplifies the process. These strategies involve minimal risk, so don’t anticipate huge profits. Yet, by making both a purchase and sale for the same asset, directional risk is removed, making it desirable to boost leverage. Moreover, unlike pair trading, calendar spreads often close same-day and can be extremely short-term in nature. Before diving into an example to explain this further, I’ll give you a brief overview of how this is done.

To begin, you’ll need to download the closing prices of the continuous futures contracts for both the near month and the following month.

By calculating the daily historic difference between the two contracts and generating a time series, we can then use the mean and standard deviation of said series to estimate the range. Trading signals are triggered when the difference moves to or past one standard deviation from the mean and closed when it returns to the average.

You got it, right?

– Calendar spread example

Using SBIN as an example, I’ve demonstrated calendar spreads.

To correctly identify the difference between two contracts, the price of near month should be deducted from current month contract. This is due to the fact that Near month contract’s futures price is generally greater than that of previous month, as outlined in Chapter 10 of Futures module.

Once the difference is determined, a time series dataset is produced as illustrated below-

I will now calculate the mean and standard deviation of this time series to get an estimate on how much variance is acceptable in terms of daily difference. Here is the snapshot.

To calculate the mean and standard deviation on excel, use the ‘=Average ()’ and ‘=stdev()’ functions respectively.

The mean of 1.227 reveals that, roughly, the spread between the two contracts should be 1.227. Consequently, no trade opportunity would arise if the difference remains at this value.

We now use the standard deviation value and the mean value to calculate the range of the spread –

Upper range = 1.227 + 0.4935 = 1.7205

Lower Range = 1.227 – 0.4935 = 0.7335

I had noted that the spread could remain around 1.227, but hadn’t specified any parameters. The range calculation does this for us, giving us a yardstick to measure daily fluctuations. Any variance away from this value could open up the chance to set up a calendar spread.

The spread is beyond the upper range of 1.7205, suggesting that either the near month contract has become more expensive or the current month contract has decreased in value.

An arbitrage is about always buying an asset in the more affordable market and selling it in the more expensive market. For this particular trade, the tactic would be to purchase a current month contract and sell a near month contract.

If the spread has dropped below its lower point of 0.7335, this indicates that the current month is more expensive and the upcoming month is a better value. To take advantage of this situation, you would need to sell the current contract and acquire the near month one.

SBIN has seen highs and lows over the past two hundred trading days, so let’s assess what openings it has provided us.

– Spotting opportunities

With this in mind, we can surmise that: 

When the spread expands beyond 1.7205, it’s time to sell the near month contract and purchase the current month one.

When the spread dips beneath 0.7335, invest in it by purchasing the near month contract and selling the current month contract.

If you’re unsure which contract to purchase or sell when you receive a signal, bear in mind the near month contract. When it comes to a sell spread, this means selling the near-month and buying the current month; similarly, buying a spread would mean buying the closeby month and selling the present one.

After looking at the excel sheet, I scanned for historical opportunities. To pinpoint the sell spread opportunities, a filter was applied to eliminate values over 1.7205. Here are my findings –

As shown, the spread exceeded 1.7205 or the first standard deviation levels on six different occasions. Each time, it triggered a sell, suggesting that the spread would return to its average.

In point of fact, this is how the spread responded –

It is evident that signals emerge near the end of each month, likely due to expiration-related effects. Each trade ended with a small gain and was closed promptly the day after.

Let us analyse how buy spread trades have done. All values below 0.7335 were filtered and the following are the results –

Almost 30 trades have been made here and not all of them yielded positive results. Losses are just as likely to occur, if not more often than profit-making. I’ve demonstrated how to determine the outcomes of the shorter ones; you can use that same formula to work out the rest.

This example should help you understand how to use calendar spread. It is certainly much easier than the traditional way of executing this strategy.

This article has outlined my ideas on Calendar spreads, which can act as the main takeaway from this chapter.

Calendar spreads generally involve limitations in the magnitude of profits and losses; these are usually small.

With directional risk removed, you can be aggressive in leveraging your investments.

The trades in SBIN that were taken on the short side turned out to be successful, suggesting that I should only seek out short opportunities when dealing with SBI. As such, it is necessary to analyse the P&L profile of each futures contract and ascertain which ones are best suited for taking longs and shorts.

Trades often are completed within a couple of days.

Trades often occur near the end of a period due to the forces at work during that time.

This is a great area to explore, as it allows you to backtest over the broad range of equities and commodities futures contracts. This gives you a chance to find signals on a daily basis!