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Chapter 15: Non-directional Trading Strategies in Commodities

14 Mins 21 Sep 2022 0 COMMENT

You might wonder whether I need to just buy and sell commodity derivatives based on market trends or if there is any other way to trade even when the market is not in my favour and reduce the risk of losing my capital.

Yes. There is a way to do it and you can develop different non-directional trading strategies, which are discussed below.

Before understanding various non-directional trading strategies, it is very important to know all about basis.

Basis

It is measure of the difference between the Spot and the Futures prices and, it is denoted as

Basis = Spot Price – Futures Price

As you are aware, the Futures price follows the price movement of their underlying asset. Apart from Spot market price movement, Futures prices are influenced by other factors such as seasonality of crops, depletion of stocks, changes in weather conditions, changes in government and central bank’s fiscal and monetary policies, etc. Basis may also vary due to changes in cost of carry due to change in interest rates, storage costs, insurance and changes in time remaining to expiry, etc.

Basis forms the most important element in derivative trading as any deviation to the basis from their actual level creates various trading opportunities and most importantly, arbitrage trading.

Basis risk

This is defined as the risk that a Futures price will move differently from that of its underlying asset. Both Spot and Futures prices carry a strong relation where Futures price follows the Spot price and the difference between them converges when the Futures contract approaches expiry.

There are two types of basis risks, and they are negative basis and positive basis.

Negative basis occurs when Futures price is greater than Spot price, which is also known as contango market.

Positive basis occurs when the Futures price is lower than the Spot price, which is also known as backwardation market.

Now, let us understand spread trading.

Spread trading

Spread refers to the difference between prices of two Futures contracts. This situation happens when one contract is undervalued, and another contract is overvalued. While initiating spread trading, traders need to have a detailed understanding about commodity fundamentals. Spreads are strategies used by traders to profit from discrepancies in market price movements by taking a long and short position simultaneously in a single commodity or between two different but correlated commodities. 

Types of spreads

  1. Calendar or intra commodity spreads

A Calendar spread is used to capitalize on the gap between the contract of the same asset but of different maturity. A trader can sell the relatively overpriced contract and buy the underpriced contract. The following example shows Nickel's March and April Future contract's current and forecasted prices. 

Price as on 25 Feb 20XX

Forecasted price as on 10 Mar 20XX

Contract

Price (Rs./kg)

Contract

Price (Rs./kg)

March 20XX

1854

March 20XX

1865

April 20XX

1847

April 20XX

1870

In this example, the April Nickel Futures are trading at a discount over the March contract. The trader expects the difference between March and April contracts to become positive. Hence, the trader sells the March contract and buys the April contract. The profit realization from this strategy, when the spread rises, is presented below.

 

March 20XX contract

April 20XX contract

Spread between Mar and Apr contracts (Rs.)

25 Feb 20XX

Sells @ Rs. 1854

Buys @ Rs. 1847

 1847 – 1854 = -7

10 Mar 20XX

Buys @ Rs. 1865

Sells @ Rs. 1870

1870 – 1865 = 5

Profit/loss

Rs. 1854 – Rs. 1865 = - Rs. 11

Rs. 1870 – Rs. 1847 = Rs. 23

 

Net profit realized

Rs. 23 + (- Rs. 11) = Rs. 12

Change in spread = 5 - (-7) = 12

The reverse can be done when the current month's contract is undervalued and the next month's contract is overvalued. In this situation, the trader buys the current month's contract and sells the far-month contract in anticipation of a reduction in the spread. In the following example, MCX Cotton for March expiry is undervalued and the April contract is overvalued. Hence, the trader will buy the March contract and sell the April contract as follows.

Price as on 25 Feb 20XX

Forecasted price as on 10 Mar 20XX

Contract

Price (Rs./Bale)

Contract

Price (Rs./Bale)

March 20XX

37100

March 20XX

37300

April 20XX

37400

April 20XX

37500

The profit realization from this strategy, when the spread reduces, is presented below. 

 

March 20XX contract

April 20XX contract

Spread between Mar and Apr contracts (Rs.)

25 Feb 20XX

Buys @ Rs. 37100

Sells @ Rs. 37400

37400 – 37100 = 300

10 Mar 20XX

Sells @ Rs. 37300

Buy @ 37500

37500 – 37300 = 200

Profit/loss

Rs. 37300 – Rs. 37100 = Rs. 200

Rs. 37400 – Rs. 37500 = - Rs. 100

 

Net profit realized

= Rs. 200 + (- Rs. 100) = Rs. 100

Change in spread = 300 - 200 = 100

2. Inter-commodity spread

This strategy involves taking long and short positions in Futures contracts in different but correlated commodities. The trading contract can be the same or different for both commodities. Some examples of inter-commodity spread are lead and zinc, aluminium and zinc, aluminium and lead, etc. 

Example: If the trader expects the spread between lead and zinc Futures to rise, then the trader can capitalize on the price movement by executing the following strategy. 

Price as on 25 Feb 20XX

Forecasted price as on 10 Mar 20XX

Contract

Price (Rs./kg)

Contract

Price (Rs./kg)

Lead 

187

Lead

190

Zinc

300

Zinc

310

Lead and zinc have a strong correlation because both are extracted from the same mine. The profit realization from executing inter-commodity spread between lead and zinc is presented below. 

 

Lead contract

Zinc contract

Spread between Mar and Apr contracts (Rs.)

25 Feb 20XX

Sell @ Rs. 187

Buy @ Rs. 300

300 – 187 = 113

10 Mar 20XX

Buy @ Rs. 190

Sell @ Rs. 310

310 – 190 = 120

Profit/loss

Rs. 187 – Rs. 190 = - Rs. 3

Rs. 310 – Rs. 300 = Rs. 10

 

Net profit realized

Rs. 10 + (- Rs. 3) = Rs. 7

Change in spread = 120 - 113 = 7

Did you know?

Agriculture commodity turns into backwardation when there is a shift from old crop to new crop, otherwise Futures contracts will always be in contango because of cost of carry added to Spot price.

Options trading strategies

Options on commodity Futures are blessings for retail investors in the commodity derivatives market. Options trading in commodity is the same as that of the stock market. However, there are three major differentiators and they are:

  1. Underlying asset in commodity Options is commodity Futures
  2. Expiry of Options contract is two days prior to commencement of tender delivery period of commodity Futures
  3. Upon expiry, open Options positions devolve into Futures contract

Irrespective of market movement, whether it is bullish or bearish or neutral market movement, you can create multiple trading strategies through Options. Some popular Option trading strategies are:

  1. Call Buy & Call Sell
  2. Put Buy & Put Sell
  3. Covered Call & Put Option
  4. Straddles and Strangles

You can refer to the Option Strategies module for more details on these strategies.

Summary

  • Apart from just buying and selling commodity derivatives, there are various non-directional trading strategies, which are very useful for investors in adverse market conditions.
  • In non-directional trading strategies, buying and selling takes place in different contracts of the same commodity or two interrelated commodities of the same contract or different contracts simultaneously where the loss in one contract/commodity is offset by gain in the other contract/commodity.
  • Spreads are the most widely used non-directional trading strategies and they are categorized as calendar spread (bull spread and bear spread) as well as inter-commodity spread.
  • Basis plays an important role while executive non-directional trading strategies providing a fair idea about market conditions.
  • Commodity Options gives ample opportunities to develop various trading strategies irrespective of market conditions such as bullish, bearish and neutral.

In the next chapter, which is the last chapter of the commodity course, you will be learning about the legal and regulatory environment of commodity derivatives, which is very essential for smooth functioning of the ecosystem. You will also learn all about dos and don’ts of commodity derivatives.

Disclaimer: ICICI Securities Ltd. (I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai - 400 025, India, Tel No : 022 - 6807 7100. I-Sec is a Member of National Stock Exchange of India Ltd (Member Code :07730), BSE Ltd (Member Code :103) and Member of Multi Commodity Exchange of India Ltd. (Member Code: 56250) and having SEBI registration no. INZ000183631. Name of the Compliance officer (broking): Mr. Anoop Goyal, Contact number: 022-40701000, E-mail address: complianceofficer@icicisecurities.com. Investments in securities markets are subject to market risks, read all the related documents carefully before investing. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The securities quoted are exemplary and are not recommendatory. Such representations are not indicative of future results. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investors should consult their financial advisers whether the product is suitable for them before taking any decision. The contents herein mentioned are solely for informational and educational purpose.