What is Rollover?

You must have heard the word rollover quite often concerning futures. Traders often refer to rollover in the stock market as long rollover or short rollover. What is rollover in trading and how exactly is it done? When are futures rolled over and what does that imply. Let us first understand what is rollover in trading parlance.

What is Rollover?

Rollover may sound like a complex and high-flying esoteric word but in reality, it is quite simple. Rollover entails switching from the near-month contract that is close to expiration to another contract. This could either be the mid-month or the far-month depending on the liquidity available and the price of rollover.

What is rollover in trading is nothing but carrying forward of your futures positions to the next settlement since the current futures will expire on the last Thursday. What if you are holding futures from a longer-term perspective? That calls for rollover of futures positions. Rollover effectively means closing your position in the contract which is about to expire and re-opening a similar new position in a further-out month contract.

Now there are 2 situations; X has bought 10 lots of Reliance Futures in the current month and Y and sold 10 lots of futures. Both need to roll over their positions. X will sell the current month and buy the next month simultaneously. That is called long rollover. On the other hand, Y will buy back the current month's futures and sell the next month's futures. That is called a short rollover. X who does long rollover will pay the rollover cost or rollover spread and Y who does the short rollover will earn that rollover spread.

Does it mean that rollover is nothing but closing the current month and initiating a similar position next month? The answer is yes. That is what rollover is all about. However, most of the big rollovers are done by large institutions and big investors. They use a rolling window where you define the roll spread and the system executes at that roll spread or better.

In a rollover, the price of rolling is not material but it is only the spread of rolling that is material. The person who does long rollover wants to ensure that they pay as low a spread as possible. The person who does short rollover will want to ensure that they earn as high a spread as possible.

The most common instance of rollover happens in arbitrage positions. In arbitrage, you buy in the cash market and sell equivalent futures to lock in the spread. For example, if you bought 250 shares of RIL at Rs.1900 and sold 1 lot of RIL futures equivalent to 250 shares at Rs.1915, then the difference of Rs.15 (1919-1900) becomes your assured arbitrage spread. That reflects the cost of funds. To realize that spread does the arbitrageur close the entire arbitrage position? No, they hold on to the cash market position and keep doing a short rollover of the futures position earning a short rollover spread each month. That is how rollover works in practice among institutions.

What are the risks of futures contracts?

One of the biggest risks associated with futures trading comes from the inherent feature of leverage. When you pay a 20% margin on futures, it is like getting 5 times leverage. That can magnify your profits 5 times but can also magnify your losses 5 times. Lack of respect for leverage and the risks associated with it is often the commonest reason for losses in futures trading. There is the price risk of the price going against you. Not to forget, there is also the risk of liquidity and solvency created by MTM margins.

What are the different strategies of F&O trading?

In the future, the strategies are not too many. You can use futures to speculate, hedge, or arbitrage in the market. Futures can be hedged by buying lower put options that are called protective put. Alternatively, you can hold on to the cash market position and sell higher call options, which is called the covered call.

Then there are volatile strategies like strangles. Here you don’t bet on markets going up or down but just bet on volatility increasing or decreasing. In strangle, you make profits either way since you buy a call and a put. Then there are variants like butterflies, collars, straddles, bull call spreads, bear put spreads; and the list of strategies can go on.