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An Institutional Effect on Spreads
The orientation of calendar spreads is the result of a combination of dynamic forces that interact together.
Those forces fall into one of two categories, intuitional influences and market factors. Institutional influences include regulatory bodies (e.g. Commodity Futures Trading Commission) that provide industry guidelines.
The proprietary firms that retain ownership of the contracts ( the “exchange”) are another example of an institutional influence.
Commodity futures contracts are often described as a financial instrument, and it becomes lost that futures are legally binding contracts.
Exchanges design clauses or specifications that provide guidelines for the longs and shorts.
A primary objective of an exchange is to include and enforce contract specifications that ensure an orderly liquidation of the open interest prior to the first delivery date.
History shows that a disorderly liquidation of the open interest may be a symptom of manipulation, specifically it may be an indication that the market is being “cornered” or “squeezed”.
A futures contract that is vulnerable to manipulation has a negative effect on the price discovery process and challenges the integrity of the contract.
A squeeze is characterized by an excessive backwardation orientation that is not supported by cash prices of the underlying product.
Contract specifications should provide a level playing field for the long and the short and is a delicate balancing act for the exchange.
Over the past thirty years exchanges have introduced contract specifications referred to as “position limits”.
Position limits were introduced in order to preserve the integrity of the contract by reducing the threat of a squeeze.
Where position limits have been introduced and levels were perceived as “restrictive”, the playing field has tilted in favor of the short.
That is, overly restrictive position limits have made it difficult/impossible for the long to take delivery. In the end this has caused calendar spreads to orient in a contango relationship and gravitate towards full carrying charges.
The introduction of position limits to the canola contract has, at times, been perceived as restrictive and resulted in the contango orientation of successive contracts.
Position limits are one example of an institutional influence on calendar spreads.
A comprehensive approach to spreads addresses all institutional influences and market factors with the approach that it is a dynamic process that complements trading strategies and may be an effective stand-alone strategy.
Happy Trading
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Nothing written, expressed, or implied here should be considered investment advice or an admonition to buy, sell, or trade any security or financial instrument. As always, do your own due diligence.