Picture this. You have a positive view on an underlying. During the expiry week, the underlying is volatile, but you expect the uptrend to continue. What should you do? In this article, we discuss how a rollover strategy can help in such scenarios. We also show how futures curve impacts the profitability of this strategy.

Rollover strategy

Suppose you have a view that an underlying will move up by 300 points. You are long on a near-month futures contract on the underlying. Fast forward in time; your contract is now approaching expiry. The underlying has moved up only 80 points. What should you do?

You could close the long position and take available profits on the futures contract. Alternatively, you should shift your long position to the next month contract if you strongly believe that the underlying could continue its uptrend. This process of shifting from one expiry month to another is called rolling over. It involves closing your long position in the near-month contract and simultaneously opening a long position in the next-month contract. It as if you are continuing with existing long position.

Rollover strategy is important for derivatives traders. Why? Reading chart patterns can provide you with a fair understanding of the directional movement in the underlying and fix a price target. It is, however, not easy to assign a time within which the target can be achieved. You may, therefore, want to roll over your existing position to achieve your price target when you continue to hold your directional view on the underlying.

It is important to time rollover. Why? Suppose you close your long position in the near-month contract for 16,000 and simultaneously buy the next-month for 16,010. You have shifted your position at a cost of ten points. That may not seem much at the outset but rolling over at a cost can erode profits, especially when you are continually shifting your position from one expiry month to another.

Hence, derivatives traders look for opportune time to roll over. You should roll over at preferably low cost. This means rollover opportunities, say, 10 days before the expiry. It also ensures that you do not get caught in a ban period — the period when you are only allowed to close your existing derivatives position (long or short) on the underlying, but not allowed to take new positions. Suffice it to know that this happens when the market wide position limit utilisation for derivatives contracts on an underlying crosses 95 per cent.

Optional reading

The next-month Nifty futures contract trades at a premium of 38 points to the near-month contract whereas the farther-month trades at 68 points premium. This shows that the cost of roll over is likely to be higher when futures curve is upward sloping. The premium is also a function of liquidity; lower the liquidity, greater the premium.

You will be able to generate roll returns when the next-month trades at a discount to the near-month contract — because buying price of the next-month contract is lower than selling price of the near-month contract. The opposite is true for rolling over a short futures position; upward sloping futures curve is beneficial whereas downward sloping curve erodes profit.

Advanced strategies involve futures curve positioning and roll procedure. Futures curve positioning refers to the choice of the expiry month to initiate a position (near-month or farther-month). Roll procedure refers to timing the closing of the initiated position and rolling into a new position. Advanced roll strategies can be gainfully implemented in commodities market, where spot price is driven by actual demand and supply from producers. This leads to interesting dynamics between spot and futures prices, translating into backwardation and contango opportunities for handsome roll returns.

The author offers training programmes for individuals to manage personal investments

 

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