The Second Leg Down by Hari P. Krishnan

Author:Hari P. Krishnan
Language: eng
Format: epub
ISBN: 9781119219002
Publisher: Wiley
Published: 2017-03-13T00:00:00+00:00

FUTURES VS SPOT

Suppose we take the view that crude oil is about to go up. We want to profit from an increase in price, but don't have the infrastructure to receive, store and deliver physical oil. A natural alternative is to buy crude oil futures. The front-month futures should move roughly in tandem with spot oil prices. By “front-month”, we mean the live contract that has the least time to maturity, yet significant open interest. In order to maintain our long position over time, we need to “roll” the contract before it expires. Rolling involves selling front-month and buying back-month futures to re-establish the position. The back month is the next active futures contract along the term structure.

Now suppose that the term structure is “in contango” at the short end of the curve. This means that front-month futures are trading at a discount to the back month. If we want to roll our long position, we need to sell low and buy high. More precisely, we have to pay (front month price–back month price) / (front month price) in percentage terms to maintain our long position. This is our roll yield and in this case is negative. The implication is that roll will materially impact our returns if we wish to hold a position for a long time. As we will see later, cumulative roll yield can have a larger impact on your overall return than changes in the spot price! When the short end of the term structure is in severe contango, it is tempting to think about buying long-dated futures. This offers two advantages. The long end tends to be relatively flat, reducing roll down from one month to the next. In addition, you don't have to roll quite so often. The trouble with this strategy is that long-dated futures can be relatively illiquid and more importantly, they might not respond enough to a jump in the spot price. When there is a supply shock in a market such as oil, front month futures tend to jump. The market prices some mean-reversion further along the curve and the effects can be muted there.

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