What is meant by calendar spread?

A calendar spread, as the name suggests is a spread strategy wherein you trade on the gap between two similar contracts rather than betting on the price. This is considered to be relatively low risk and more predictable strategy compared to taking a directional view on the Nifty or on individual stocks. Calendar spread trades are very common among institutions and HNIs who look at low-risk strategies where it is possible to make large rupee returns based on volumes. Retail investors normally may not have the expertise and the capital needed for such calendar spread strategies.

Let us look at what is Calendar spread and how it works in practice? We will start with the Calendar spread definition in the first place.

What is a calendar spread?

The Calendar spread definition can be understood in terms of the simultaneous purchase and sale of two futures contracts on the same underlying for different maturity contracts. For example, you can create a calendar spread between Nifty June and Nifty July by buying into one contract and selling into the other contract. This way, your payoffs on the calendar spread are based on the spread either widening or narrowing. For example, the Calendar spread definition says that when you expect the spread to widen, you go long on the Calendar spread, and when you expect the spread to narrow, you go short on the Calendar spread.

Process flow for a calendar spread

Remember, that Calendar spread can be done in options and also in futures. In the Indian context, both are popular but we will focus on calendar spread on Nifty futures for simplicity. The logic will remain the same for Calendar spreads on options also. As the first step in the Calendar spread, you must calculate the fair value of the current month's contract. In the second step, you can calculate the fair value of the mid-month or the far-month contract. Once you see the mispricing, you can buy the under-priced contract and sell the overpriced contract. That creates your Calendar spread.

Based on the relative mispricing, you either buy the current month's contract or sell the mid-month contract. Alternatively, you can also sell the current month's contract and buy the mid-month contract. There is no bar on the same. Let us take a live instance.

You buy RIL June Futures at Rs.2,245 and Sell RIL July futures at Rs.2,250. Here your spread is Rs.5 and you expect the spread to shift so that you can make a profit. Let us assume that after a few days, the RIL June futures go up to Rs.2260 and the RIL July futures go up to Rs.2,257. Now if you close the calendar, you earn Rs.15 on June futures but you lose Rs.7 on the July Futures. In short, you have made a profit of Rs.8 on the calendar spread.

However, you normally look at this in terms of the spread. The spread moved from a positive of Rs.5 to a negative of Rs.-3 giving you a net profit on the calendar spread of Rs.8. That is how profits on spreads are earned. Normally, the risk on such calendar spreads is quite limited.

Important points to note in the Calendar spread

Note that in a calendar spread you are buying and selling the futures of the same stock but of contracts belonging to different expiries like in the case of Reliance Industries above. The difference between the prices of the two contracts is what is expected to make here. Of course, in our case above, you got an added benefit because the calendar shifted from positive spread to negative spread giving you a much bigger profit. Since trading risk is very low in calendar spreads, the profits that you make on calendar spreads are also relatively small. That is why this is more for risk-averse institutions who look at volumes to earn rupee profits.

Now we come to the last aspect of the calendar spread. How do you decide whether the particular contract is under-priced or overpriced? For that, you must adopt the basis approach or the cost of carrying approach. The futures price is the expected stock price. In other words, the spot price is nothing but the present value of the expected futures price. Based on the cost of carrying method you can figure out which contract is under-priced and which is over-priced. Then you accordingly, buy the under-priced contract and sell the overpriced thus creating a calendar spread in the process.

Just one word of caution. A calendar spread remains low risk only if you continue to hold the position as a spread. For example, if you are making a profit on one leg then just booking profits on that leg and just holding on to a naked position in the other leg is the wrong approach. Then you break the logic of the calendar spread and it becomes a speculative trading position with huge risk implications. So, the Calendar spread has to be initiated and closed as a combined strategy only.

What is reverse calendar spread?

The concept of a reverse calendar spread is more popular when you trade on calendars in options. Her is how the reverse calendar spread works out. It entails buying a short-term option and selling a long-term option on the same underlying security with the same strike price. For example, you buy a June 1500 Infosys call option and sell an August 1500 Infosys call option. That is an example of a reverse calendar spread.

Here is how the reverse calendar spread will work in practice. Most spreads are constructed as a ratio spread with investments made in unequal proportions or ratios. A reverse calendar spread is normally the most profitable when markets make a huge move in either direction. It is more common among institutions rather than among individuals due to its complex structure and higher margin requirements.

What are derivatives?

In capital markets, a derivative is defined as a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the underlying. Some of the most popular derivative contracts are forwards, futures, options, and swaps.