Inter delivery Spread

Highlights

• Involves buying and selling different delivery months of the same futures contract.
• Profits from changes in the price difference between contract months.
• Used by traders to capitalize on market fluctuations while managing risk.

An inter delivery spread is a trading strategy used in the futures and options markets that involves simultaneously buying and selling contracts of the same underlying asset but with different delivery months. The goal is to profit from the change in the price difference, or “spread,” between the two contract months. Traders anticipate that this spread will either widen or narrow, depending on market conditions and other influencing factors, such as supply and demand dynamics, seasonal trends, or economic events. This strategy is commonly used by investors looking to capitalize on price movements while managing risk exposure.

Understanding Inter delivery Spreads

Inter delivery spreads involve the simultaneous purchase of one contract month and the sale of another month of the same underlying asset. For example, a trader might buy a June crude oil futures contract while selling a December crude oil futures contract. The objective is to profit from the change in the price difference between the two delivery months.

This strategy differs from outright trading, where a trader simply buys or sells a single futures contract to speculate on price direction. In an inter delivery spread, the focus is on the relationship between two contract prices, rather than the absolute price level. This approach allows traders to take advantage of price discrepancies while reducing the overall risk exposure to market volatility.

How Inter delivery Spreads Work

The basic concept behind an inter delivery spread is to exploit changes in the price difference between two delivery months. This price difference is influenced by factors such as supply and demand, seasonal trends, interest rates, and economic events. Traders can use inter delivery spreads to profit from:

• Widening Spreads: Occurs when the price difference between the two contracts increases. For example, if the December contract price rises more than the June contract price, the spread widens.
• Narrowing Spreads: Occurs when the price difference between the two contracts decreases. For instance, if the December contract price increases less than the June contract price, the spread narrows.

Types of Inter delivery Spreads

Inter delivery spreads can be categorized into two main types:

1. Bull Spread:

A bull spread is used when a trader expects the price difference between the near-month contract and the far-month contract to widen. In this strategy, the trader buys the near-month contract and sells the far-month contract. If the price of the near-month contract increases relative to the far-month contract, the spread widens, resulting in a profit.

Example:

• Buy June Crude Oil Futures at $80 per barrel.
• Sell December Crude Oil Futures at $85 per barrel.
• If the spread widens to $7 (e.g., June at $83 and December at $90), the trader gains from the price increase in the near-month contract relative to the far-month contract.

1. Bear Spread:

A bear spread is used when a trader expects the price difference between the near-month contract and the far-month contract to narrow. In this strategy, the trader sells the near-month contract and buys the far-month contract. If the price of the near-month contract decreases relative to the far-month contract, the spread narrows, leading to a profit.

Example:

• Sell June Corn Futures at $6 per bushel.
• Buy December Corn Futures at $6.50 per bushel.
• If the spread narrows to $0.30 (e.g., June at $5.80 and December at $6.10), the trader benefits from the decline in the near-month contract relative to the far-month contract.

Why Traders Use Inter Delivery Spreads

Trader’s use inter delivery spreads for several reasons:

1. Reduced Risk Exposure: By holding both long and short positions in the same underlying asset, traders can reduce their exposure to market volatility. This is because price changes in one contract month are often correlated with changes in another month, minimizing the impact of adverse price movements.
2. Lower Margin Requirements: Compared to outright futures positions, inter delivery spreads typically require lower margin deposits due to the reduced risk associated with holding offsetting positions.
3. Exploiting Price Discrepancies: Traders can take advantage of temporary price discrepancies between contract months that may be influenced by seasonal factors, supply and demand changes, or economic events.
4. Hedging: Producers and consumers of commodities use inter delivery spreads to hedge against price fluctuations by locking in favorable prices for future delivery months.

Factors Influencing Interdelivery Spreads

Several factors can influence the price difference between contract months, including:

1. Supply and Demand Dynamics: Changes in supply and demand conditions, such as crop yield reports, crude oil inventories, or industrial production levels, can impact the spread between contract months.
2. Seasonality: Seasonal trends, such as increased demand for natural gas during winter or agricultural cycles affecting grain prices, can create predictable patterns in inter delivery spreads.
3. Interest Rates and Carrying Costs: The cost of carrying the underlying asset, including storage and financing costs, can affect the price relationship between different delivery months.
4. Market Sentiment and Speculation: Speculative activity and market sentiment can cause short-term fluctuations in inter delivery spreads as traders react to news events or economic data releases.

Example Scenario

Consider a trader analysing the crude oil market. They observe that the June crude oil contract is trading at $80 per barrel, while the December contract is trading at $85 per barrel. Anticipating increased demand in the short term due to seasonal refinery maintenance, the trader expects the price of the June contract to rise faster than the December contract, causing the spread to widen.

To capitalize on this expectation, the trader enters into a bull spread by buying the June contract and selling the December contract. If the spread widens from $5 to $7, the trader profits from the relative price increase in the June contract compared to the December contract.

Advantages of Inter delivery Spreads

• Reduced Risk and Volatility: Since the long and short positions offset each other, inter delivery spreads are generally less volatile than outright positions.
• Lower Margin Requirements: Exchanges typically require lower margins for spread trades due to the reduced risk exposure.
• Profit from Relative Price Movements: Traders can profit from changes in the price relationship between delivery months, regardless of the overall market direction.

Challenges and Limitations

• Complexity in Analysis: Analyzing the factors that influence the price spread between contract months can be complex, requiring in-depth knowledge of market dynamics.
• Potential for Losses: If the spread moves in the opposite direction than anticipated, traders can incur significant losses.
• Limited Liquidity: Some contract months may have lower trading volumes, leading to reduced liquidity and wider bid-ask spreads.

Conclusion

Inter delivery spreads are a powerful trading strategy used in the futures and options markets to profit from changes in the price difference between different delivery months of the same contract. By buying and selling contract months simultaneously, traders can capitalize on market fluctuations while minimizing risk exposure. This strategy is particularly useful for managing volatility, lowering margin requirements, and exploiting price discrepancies caused by seasonal trends, supply and demand changes, and economic events. Although inter delivery spreads offer reduced risk and volatility compared to outright positions, they require careful analysis of market dynamics and carry the potential for significant losses if the spread moves against the trader’s position. Nevertheless, for traders who understand the intricacies of price relationships and market behavior, inter delivery spreads provide an effective tool for profit generation and risk management.