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For example, I am using a buy and hold strategy for commodities futures. When spot month close to expiry, I rollover my contract to next month.

However, the next month contract are usually wont equal price with the spot month, which would result in some gain or loss.

For example: if I close my long position of spot month at price $2000, and roll to next month to buy at $2010, I am paying extra $10 in the rollover.

Another case is, if I close my spot month long position at $2000, and roll to next month to buy at $1990, I earned $10 in the rollover.

Technically, I didn't pay or earn extra $10, but currently I am running a backtest on a strategy which did not factor in rollover cost. I am wonder, in the long run, will they even out?

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    I don't have the ability to offer a full answer right now. Lookup the word Contango. It's the phenomenon you describe, and it can cost a trader who got the trade direction correct but was off on timing. – JoeTaxpayer Aug 25 '15 at 14:07
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    Contango can reverse and become backwardation. Please refer to Spot–future parity. – base64 Aug 25 '15 at 15:04
  • Don't people solve this problem using calendar spreads? If you buy (or sell) the spread in the opposite direction of the trade you're about to make, then the rollover itself would cost/earn you $0 (minus transaction fees). – dg99 Aug 25 '15 at 15:11
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    The price differential when rolling from one contract to another is not a "gain" or a "loss". For backtesting strategies you can eliminate this roll gap by generating a data set of continuous contracts that uses some sort of adjustment method (such as back adjustment) to remove the roll gap. – Norgate Data Aug 25 '15 at 22:30
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There are 2 schools of thought in determining the price of a future contract in a day prior to expiration.

The cost of carry model, states that the price of a future contract today is the spot price plus the cost of carrying the underlying asset until expiration minus the return that can be obtained from carrying the underlying asset.

FuturePrice = SpotPrice + (CarryCost - CarryReturn)

The expectancy model, states that the price of the futures contract depends on the expectation about the spot market's price in the future. In this case, the price of the future contract will diverge from the spot price depending on how much the price is expected to rise or fall before expiration.

A few glossary terms:

cost of carry

For physical commodities such as grains and metals, the cost of storage space, insurance, and finance charges incurred by holding a physical commodity. In interest rate futures markets, it refers to the differential between the yield on a cash instrument and the cost of funds necessary to buy the instrument. Also referred to as carrying charge.

spot price

The price at which a physical commodity for immediate delivery is selling at a given time and place. The cash price.

  • Thanks for your answer. However, for cost of carry model, how can it explain backwardation? – VHanded Oct 24 '15 at 8:55
  • The causes leading to backwardation are subject of plenty of academic debate to this date, and are not easy to explain even without limiting the context to a particular school of thought for the pricing of futures. – PabTorre Oct 25 '15 at 0:37

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