Spread Trading
Spread trading is a core strategy in commodity derivatives where a trader simultaneously takes opposite positions in two related contracts. It helps manage price risk, reduce margin requirements, and exploit relative price movements. The NISM exam tests your understanding of spread types, payoff calculations, and regulatory limits. Mastering this sub‑topic will enable you to answer scenario‑based questions confidently.
Learning Objectives
- 1Define spread trading and differentiate it from outright positions.
- 2Identify and describe the major types of commodity spreads.
- 3Calculate profit or loss for calendar and inter‑commodity spreads.
- 4Recall SEBI/MCX rules specific to spread positions.
What is Spread Trading?
A spread is a simultaneous long and short position in two related commodity futures contracts. The trader does not own the physical commodity; instead, the profit depends on the change in the price differential between the two legs.
Because the two legs move in the same direction most of the time, the overall market exposure (beta) is lower than an outright position. This lower exposure translates into reduced margin requirements, which is a key advantage for Indian distributors and brokers.
In the NISM Series XVI exam, spread‑related questions often present a price scenario and ask for the net payoff, or they test knowledge of which spreads are permitted under SEBI regulations.
- Spread = Long leg – Short leg
- Profit = Change in price differential × contract size
Students sometimes treat a spread like a simple arbitrage. Remember, a spread is a directional bet on the *relative* price movement, not a risk‑free profit opportunity.
Major Types of Commodity Spreads
Calendar (or Time) Spread: Long one contract month and short another month of the same commodity. The aim is to profit from the change in the futures curve (contango or backwardation).
Inter‑Commodity Spread: Long a contract in one commodity and short a contract in a related commodity (e.g., crude oil vs. gasoline). This exploits the price relationship between the two commodities.
Crack Spread: A specific inter‑commodity spread used by refiners, representing the margin between crude oil and its refined products such as gasoline and diesel.
Exam questions may ask you to match a spread type with its typical use‑case or to calculate its payoff.
Comparison of Common Commodity Spreads
| Spread Type | Underlying Contracts | Primary Purpose | Typical Users |
|---|---|---|---|
| Calendar Spread | Same commodity, different expiry months | Capture changes in term structure | Speculators, hedgers adjusting exposure |
| Inter‑Commodity Spread | Related commodities (e.g., wheat & corn) | Exploit relative price moves | Processors, traders with cross‑commodity exposure |
| Crack Spread | Crude oil vs. refined products | Measure refinery margin | Refiners, commodity analysts |
Mechanics of a Calendar Spread
To initiate a calendar spread on the MCX, a trader buys (goes long) a near‑month futures contract and sells (goes short) a far‑month contract of the same commodity. Both legs are entered at the same time, and the net cash outflow is the difference in the two premiums.
The profit or loss is realized when the price differential widens or narrows. Because the two contracts share the same underlying, the spread’s exposure to overall market moves is limited, which is why SEBI permits lower margin for spread positions.
Key exam points include: (i) identifying the long and short legs, (ii) using the contract size to convert price differential into rupee profit, and (iii) remembering that settlement is based on the final settlement price of each leg on expiry.
Where:
P_{\text{long}}= Futures price of the long leg (Rs per unit)P_{\text{short}}= Futures price of the short leg (Rs per unit)Q= Contract size (units per contract, e.g., tonnes)Worked Example
Given P_{long}=4,500 Rs, P_{short}=4,300 Rs, Q=10 tonnes: Step 1: Difference = 4,500 - 4,300 = 200 Rs/tonne Step 2: Payoff = 200 \times 10 = 2,000 Rs Verification: (4,500 - 4,300) \times 10 = 2,000.
Scenario
An Indian trader enters a calendar spread on gold by buying the September contract at Rs 45,200 per 10 grams and selling the December contract at Rs 44,800 per 10 grams. Each contract represents 100 grams (i.e., 10 lots of 10 grams).
Solution
First calculate the price differential: 45,200 - 44,800 = 400 Rs per 10 grams. Convert to per‑gram: 400 / 10 = 40 Rs per gram. The total contract size is 100 grams, so payoff = 40 Rs/gram × 100 grams = 4,000 Rs. If at expiry the September contract settles at 45,500 and the December at 44,600, the new differential is 900 Rs, giving a payoff of 9,000 Rs, showing a widening spread and a profit of 5,000 Rs over the initial position.
Conclusion
The trader’s profit depends solely on the change in the price gap, not on the absolute movement of gold prices, which is a typical calendar spread outcome tested in the exam.
Inter‑Commodity Spread (Crack Spread) Mechanics
An inter‑commodity spread involves taking opposite positions in two related commodities. The classic example in India is the crack spread: long crude oil futures and short gasoline (or diesel) futures. The spread reflects the refinery margin, i.e., how much profit a refinery can earn per barrel after processing.
Because the two commodities are linked by physical processing, their prices often move together, but the relative price can change due to supply‑demand imbalances, taxes, or seasonal factors. Traders use this spread to hedge refinery exposure or to speculate on changes in the refining margin.
On the NISM exam, you may be given the closing prices of crude and gasoline futures and asked to compute the crack spread payoff, or to identify which leg is long/short for a given market view.
Where:
P_{\text{commodity\,A}}= Futures price of the long commodity (Rs per unit)P_{\text{commodity\,B}}= Futures price of the short commodity (Rs per unit)Q= Contract size common to both legs (units per contract)Worked Example
Assume a trader goes long crude oil at 4,200 Rs/ barrel and short gasoline at 3,800 Rs/ barrel. Contract size = 1 barrel. Step 1: Difference = 4,200 - 3,800 = 400 Rs Step 2: Payoff = 400 \times 1 = 400 Rs per spread contract Verification: (4,200 - 3,800) \times 1 = 400.
Scenario
A refinery expects gasoline prices to rise faster than crude oil over the next month. It enters a crack spread by buying 5 crude oil futures (MCX) at Rs 4,150 per barrel and selling 5 gasoline futures at Rs 3,900 per barrel. Each contract represents 1 barrel.
Solution
Initial spread = 4,150 - 3,900 = 250 Rs per barrel. Total initial payoff = 250 × 5 = 1,250 Rs (negative cash flow because the short leg is sold). After one month, crude settles at 4,300 and gasoline at 4,200. New spread = 4,300 - 4,200 = 100 Rs. Final payoff = 100 × 5 = 500 Rs. Change in spread = 500 - 1,250 = -750 Rs, indicating a loss because the gasoline price did not increase as expected.
Conclusion
The example shows that a crack spread profit hinges on the relative price move, not the absolute rise of either commodity—a nuance frequently examined.
When calculating spread payoff, always use the official settlement price of each leg on the expiry date, not the intraday closing price shown on charts.
Risk Management in Spread Trading
Although spreads reduce overall market exposure, they are not risk‑free. The primary risk is *basis risk* – the possibility that the price relationship between the two legs changes unfavorably.
Margin requirements for spreads on MCX are typically 30‑40% of the outright margin, but traders must monitor the *roll‑over risk* when the near‑month contract expires and a new spread must be created.
For the exam, remember that SEBI mandates daily mark‑to‑market and that a breach of the spread’s maintenance margin triggers a margin call for the entire spread position, not just one leg.
Profit/Loss Profile: Calendar Spread vs. Outright Position
Regulatory Framework (SEBI & MCX)
SEBI permits spread trading for all categories of market participants, provided they are registered as commodity brokers, sub‑brokers, or as eligible investors. Position limits for spreads are set on a *net* basis, i.e., the difference between long and short contracts, which is usually higher than the limit for an outright position.
All spread transactions must be reported in the daily position statement submitted to MCX, and the exchange’s risk management system monitors the *spread margin* separately from the outright margin.
Exam questions may ask about the reporting requirement, the net‑position limit concept, or the specific margin percentage applicable to spread trades on MCX.
Do not add long and short contracts when checking SEBI’s position limits. Use the net difference (long – short) for spreads.
Practical Considerations for Indian Traders
MCX offers calendar spreads for most listed commodities such as gold, silver, crude oil, and agricultural products. Contract specifications (lot size, tick size, expiry) are standardized, making it easy to calculate the rupee value of a spread.
Liquidity is highest for the front‑month contracts; therefore, traders often close the spread before the near‑month expires to avoid ill‑liquidity in the far‑month leg.
When preparing for the NISM exam, remember the typical lot sizes (e.g., 1 kg for gold, 100 tonnes for crude) as they are required to convert price differentials into monetary profit.
⭐Exam Takeaways
- Spread trading = simultaneous long and short in related futures; profit = change in price differential × contract size.
- Calendar spread uses the same commodity across different expiries; inter‑commodity (crack) spread uses related commodities.
- Payoff formula: (P_long – P_short) × Q. Use official settlement prices for both legs.
- SEBI allows lower margin for spreads; position limits are based on net contracts, not gross.
- Key risks: basis risk, roll‑over risk, and margin calls on the spread as a whole.
Practice Questions
8 questions on Spread Trading
What best defines spread trading in commodity futures?
Which type of spread involves the same commodity but different expiry months?
A trader initiates a calendar spread on a commodity with P_long = 4,500 Rs, P_short = 4,300 Rs and contract size Q = 10 tonnes. What is the payoff of the spread?
Which market participant is most likely to use a crack spread?
A refinery buys 5 crude oil futures at 4,150 Rs/barrel and sells 5 gasoline futures at 3,900 Rs/barrel. After one month crude settles at 4,300 Rs and gasoline at 4,200 Rs. What is the net change in the spread payoff?
According to SEBI regulations, how are position limits for spread trades calculated?
What is the primary risk unique to spread trading compared to an outright futures position?
What margin percentage is typically applicable to spread positions on MCX?