Mastering Derivatives: Roll over your contracts

Having multiple expiry dates on futures contracts allows you to engage in roll strategy. Though roll strategy is more beneficial in commodity futures, this week, we discuss the strategy in relation to single-stock futures and index futures.

Roll strategy

A roll is a simple strategy of closing a long position in a near-dated contract and simultaneously initiating a long position in a farther out contract. For example, you could first initiate a long position in April Nifty Futures. Just before the expiry of the April contract, you can close the long position and immediately initiate a long position in the May contract.

You could argue that this is technically closing the near-dated contract and opening a fresh position in the next-dated contract. True, it is. But traders consider this as continuation position whose expiry has been extended by a month or more. This strategy could be meaningful in two scenarios. One, your initial price target has been achieved, but you still believe that the uptrend is intact. And two, your price target has not yet been achieved and you believe it will be achieved in a while.

A more sophisticated roll strategy involves two choices — futures curve positioning and roll procedure. In financial futures, the futures curve is typically upward sloping. That is, the May futures price is likely to be greater than April futures price, and the June futures is likely to be greater than May futures price. Note that NSE offers three dated futures contract at any given time- the near month, the middle month, and the farther month. So, curve positioning trade involves deciding the contract on which you should initiate a long position. This must depend on the implied rate, which is found through the futures valuation model (F= Se^rt). The implied rate in the equation is r. You must initiate a long position in the contract, which has the lowest r among the three contracts.

The next choice is the roll procedure, which refers to when you will close the existing long position and open a fresh long position of a longer expiry. Note that this depends on the slope of the curve. When the futures curve is upward sloping, the roll procedure will incur a cost, because new contract you buy will carry a higher price than the old contract you close.

Roll choices

A more sophisticated roll strategy involves two choices — futures curve positioning and roll procedure

Optional reading

Traders typically rollover Nifty futures from the near-month contract just before expiry to the immediate next-month contract. The strategy is more a play on extending time on the long position than a bet on curve positioning and roll procedure. Futures curve positioning is more meaningful in the commodity markets where prices can be in contango or backwardation. Suppose there is high demand for a commodity now because it is used as an input in production. Crude, for example. Then, its spot price may be higher than the futures price (backwardation). Often, however, futures price will be higher (contango).

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