The rollover cost is the financial difference incurred when extending a position in a futures contract from one expiry month to the next.
Understanding Rollover Cost in Futures Trading
In futures trading, a rollover is the process of moving an existing position from a near-month (soon-to-expire) futures contract to a far-month (later-expiring) futures contract. The financial implication of performing this action is known as the rollover cost, which can also be referred to as a rollover premium or discount. It represents the cost or gain associated with switching contracts.
How to Calculate Rollover Cost
The rollover cost is essentially the price difference between the futures contract being sold (the near-month contract) and the futures contract being bought (the far-month contract) to maintain the position for the subsequent expiry cycle.
The formula for calculating the rollover cost is:
Rollover Cost = Price of Far-Month Contract - Price of Near-Month Contract
A positive result indicates a cost incurred, while a negative result suggests a gain or discount.
Practical Example of Rollover Cost
Let's consider a scenario where a trader holds a futures position in the May contract and decides to roll it over to the June contract to extend their exposure.
Action | Contract Month | Price (Points) |
---|---|---|
Price at which you sold | May | 22,500 |
Price at which you bought | June | 23,000 |
Based on the prices above, the calculation for the rollover cost would be:
- Rollover Cost = Price of June Contract - Price of May Contract
- Rollover Cost = 23,000 - 22,500
- Rollover Cost = 500 points
In this example, the rollover cost is 500 points, meaning the trader incurred this cost to extend their futures position from May to June. This cost is a critical factor that traders must account for as it directly impacts the overall profitability of their trading strategy.
Key Factors Influencing Rollover Cost
Several elements can impact the size and direction of the rollover cost:
- Market Contango or Backwardation: These market structures, where far-month contracts are priced higher (contango) or lower (backwardation) than near-month contracts, directly determine whether a rollover incurs a cost or provides a benefit.
- Interest Rate Differentials: For currency futures, differences in interest rates between the two currencies can influence the cost of carrying a position forward.
- Supply and Demand Dynamics: The demand and supply for specific contract months can create price disparities, affecting the rollover cost.
- Underlying Asset's Fundamentals: Expected dividends for equity futures or storage costs for commodity futures can also play a role in the pricing difference between contract months.
Why Understanding Rollover Cost is Crucial
For active futures traders, comprehending rollover costs is vital for several reasons:
- Profitability Assessment: It directly affects the net financial outcome of a trade. Ignoring it can lead to underestimating actual costs.
- Strategic Decision-Making: Knowledge of rollover costs helps traders decide whether to roll over, close a position, or open a new one in the next cycle.
- Risk Management: Incorporating potential rollover costs into risk assessments allows for more accurate capital allocation and better position sizing.