During the last week of December, while the entire commodity market was taking a breather, the domestic commodity exchanges came up with circulars on spread margins that may not only drive away the hedgers from the market this year but also derail the price discovery mechanism.
While the old saying “fake it till you make it” worked for a large number of myopic stances taken due to regulatory directions, this will certainly kill the physical market’s participation in the domestic exchanges.
Let us first understand the fundamentals of spread; spread is the simultaneous purchase of one futures contract and the sale of a different contract. The futures contracts can be different delivery months in the same commodity; or they can be two different commodities spread against each other. Or, they can be the same commodity traded on two different futures exchanges (currently, almost non-existent in India).
One might ask why people trade spreads when they can just as easily buy one futures contract and sell another one via separate transactions and hedge their risks. An important reason to place a spread order, rather than orders for the individual components of the spread, involves order-placing strategy.
When you trade the spread, you lock in the price differential between the “legs” of the spread, often by specifying the exact differential. If you try to trade the spread by placing two different market orders, for instance, many things could happen between the time you place your order and the time both orders are filled.
Thus, a single-spread order can be more predictable and less risky than multiple individual orders. Almost a decade ago, the R.V. Gupta Committee Report had recommended about spread: “So long as anticipated physical exposure levels appears prima facie to be reasonable, it would be unduly restrictive to bar the firms concerned.”
Internationally, the spread trade margins are continuously being reduced. Comex had cut the spread margin on September 7 to between 56 per cent and 76 per cent. Internationally spread hedges are being promoted to cover price risk. The recent circulars will create not only volatility in margins but also expose the futures market to unnecessary cash flow volatility, thus creating market distortions.
While the exchanges are trying to embark on a VaR-based margining system for individual futures contract, the revised calculation of the spread-based margining and the ambiguity in calculation (not based on VaR) leaves a lot to be desired.
Strategies of the Hedgers
Spreading strategies assume that both the long and short contracts used in the spread are affected by the same economic circumstances. As a result, prices of the long and short are expected to move generally in sync. If, for some reason, the prices of the two futures do not move together, then an opportunity to book profit by physical players may arise.
If the hedger believes that current price relationships between related futures contracts are out-of-line, then he or she would buy the relatively under-priced contract and sell the relatively overpriced. If the two contracts move back to the expected price relationship, then the hedger protects the profit.
Physical traders, by doing spread trading, reduce speculative activity in the futures market. For example, if the nearby futures contracts for maize are gaining in price relative to the deferred contracts, this generally indicates more demand or less supply, or both. It’s a strong signal that fundamentals are bullish and prices may well move still higher.
However, if the nearby maize futures do not gain on the deferred during an upmove, the trader may deduce that the recent price advance has been technical in nature and not backed by bullish fundamentals, and that a sell-off may be close at hand. Thus, the spread trading helps in the “price discovery” — the foremost function of the futures market.
It has been said that most spread traders rely heavily on fundamental analysis when employing their spread trades,
Spread trading in futures markets does not get a lot of attention among speculative traders. This is because of the complexity that tracking and analysing some spreads can entail. Many hedgers do employ this method of trading because it can be less risky and less expensive than trading straight futures contracts.
Spread trading usually involves less risk than trading straight futures. Because storable commodities have “carrying charges,” spreads rarely go beyond a certain level that is known to hedgers. This means a trader can initiate a spread and know to a fairly certain degree how much risk is involved. There are some spreads that do involve higher volatility, such as inter-commodity spreads; however, these are non-existent in Indian conditions.
Spread and physical market
In the grain business, the difference between two contract months of the same commodity (i.e. maize) represents the carrying charges or the cost of holding the commodity for a period of time.
Carrying charges are determined by the cost of interest and storage when physical commodities are held in store. (not necessarily in the exchange approved warehouse).
Grain traders monitor spread relationships very closely as the relative difference between various contract positions determines the handling margins or profitability of their involvement in marketing grain.
When using spreads, the hedgers hope to protect profit by changes in the spread (difference) between the two contracts. The hedger is looking for either a widening or narrowing of the spread relationship over time. Spreads are used when the difference in prices between the long and short contracts is considered to be "out-of-line".
Commodity-Product Spreads
A commodity-products spread comprises a long position in a commodity against short positions of an equivalent amount of the products derived from it, or vice-versa. A well-known example of a commodity-products spread is the so-called soybean crush, which involves going long on raw, unprocessed soybeans again short positions in soybean products – soybean meal and soybean oil.
The soybean crush gets its name from the fact that when soybeans are “crushed” in processing, two products are made, meal and oil. A “reverse” crush is a spread in which soybean futures are sold and soybean oil and meal futures are bought. Traders undertake the crush (or reverse crush) when the price relationship between processed and unprocessed soybeans is different from what they expect.
Risk management tool
Spread hedges are considered to be a less risky and often less expensive way in which to participate in the futures market. Spread trading is more complicated than outright trading and requires a higher degree of sophistication on the part of the trader. By monitoring the relative strength between various contracts and between different markets, one will be better able to select the appropriate pricing and risk management strategies when developing the marketing plan.
In conclusion, spreads, when used by physical market players and hedgers, can be a key tool to managing the risk in a position while maintaining a profit potential as spread hedges are less sensitive to market direction predictions of the individual contracts and it may be easier to predict market relationship patterns than price direction.
Published in The Business Line 25 Jan, 2008
