In the world of derivatives trading, "roll forward" is an essential strategy for investors looking to extend the duration of their positions. This article delves into what roll forward means, its mechanics, types of contracts involved, and practical applications.
What is Roll Forward?
Roll forward refers to the practice of closing an expiring option, futures contract, or forward agreement and simultaneously opening a new contract with a later expiration date for the same underlying asset. This allows traders to maintain their market position beyond the expiration of the initial contract, which is crucial since derivatives have finite lifespans.
This process typically occurs shortly before the initial contract's expiration, ensuring that any gains or losses from the original position are settled before the new position is assumed.
The Mechanics of Roll Forward
The roll forward process comprises two primary steps:
- Exit the Initial Contract: Traders close their existing position that is about to expire.
- Initiate New Position: They open a new contract with a later expiry date for the same underlying asset, ideally executing both transactions simultaneously. This reduces slippage—the loss of potential profits due to changes in the asset's price between the two transactions.
The execution of these steps may vary slightly based on the type of financial instrument being traded.
Key Takeaways
- Definition: Roll forward is a method of extending a derivatives contract by closing out an expiring position and opening another at current market prices.
- Common Instruments: The strategy is frequently used with options, futures contracts, and forward agreements.
roll forward usually adopted with these instruments
1. Options
In options trading, a roll forward can involve utilizing the same strike price in both contracts or adjusting to a new one. If the new contract has a higher strike price, it is termed a "roll up." Conversely, a "roll down" occurs when the new strike is lower. These strategies are beneficial for profit protection or hedging against losses.
Example:
A trader with a June call option on Widget Company, set at a $10 strike price, can either:
- Roll Up: Switch to a September call option at a $12 strike, thereby protecting part of the profit as the stock trades at $12 at expiration.
- Roll Down: If they anticipate a decrease in the stock price, they may switch to a lower strike price option to reduce potential losses.
2. Forwards
In the case of foreign exchange contracts, roll forwards often take place when the maturity date aligns with the spot date. For example, if an investor has a forward contract to purchase euros at a specific rate, as the contract nears expiration, they can execute a swap to maintain their currency exposure.
Example:
If an investor bought euros at an exchange rate of 1.0500 and finds the market rate at 1.1050 as the expiry approaches, they could close the current contract and open a new one at the current rate plus or minus forward points.
3. Futures
Futures contracts require particular attention to deadlines. Traders must either close their position before the First Notice Day (for physical delivery contracts) or prior to the Last Trading Day (for cash-settled contracts). The closing is usually executed for cash, followed by establishing a new futures position with an extended expiration date.
Example:
A trader holding a long position in a crude oil futures contract at $110 with a June expiry must exit this position before expiration and open a new contract at the prevailing market price for a later date.
Conclusion
Roll forward is a pivotal strategy within derivatives trading, allowing traders to extend their positions in a strategic manner. Whether utilizing options, forwards, or futures, effectively executing a roll-forward strategy involves careful market assessment and timely decisions to optimize potential gains and minimize losses. Understanding the nuances of this practice can enhance traders' abilities to navigate the complexities of financial markets and maintain their investment edge over time.