As a futures trade approaches expiration, there are two things a trader can do (assuming that they do not want to take delivery of the physical goods being traded - any futures contract not requiring delivery gets settled to cash). Traders can choose to close out a futures contract before expiration and take any profits or losses or roll the contract forward. Rolling a futures contract forward is the process of carrying a futures contract forward from one expiration date to a further out expiration date.

Determining When To Roll

Rolling a futures contract allows a trader to extend duration of a trade, but when rolling, the trade can come at a discount or a premium depending on open interest/volume. When we see open interest shift or volume shift, that’s when we may want to roll.

We can actually calculate the value of a roll to determine if rolling a position is better given our assumption rather than just closing out the contract before expiration.

Calculating The Roll Value

Calculating the value of rolling a futures contract forward is actually quite simple. One simply takes the nearby futures price and subtracts it from the deferred future price.

Roll = Deferred Future Price - Nearby Future Price

Once the roll value is calculated, then we want to look and see if the price of the roll fairly reflects market conditions or not. We assess the ‘fair value’ of a stock index future by incorporating the cost of carry (the cost of buying and carrying an equity portfolio until term that reflects the value of the underlying index). The cost of carry can be positive or negative and can be determined by figuring out the future value of the stock index futures contract.

How To Calculate The Future Value Of A Futures Contract

It’s important to understand the relationship between the short-term interest rates and dividends, which dictate whether positive or negative carry prevails. Futures at lower prices in deferred months reflect a positive cost of carry, meaning that dividend earnings are greater than financing costs.

To find what the value of a futures contract is in the future, we take the spot price, plus the cost of financing the position and subtract out the dividends.

FV Futures = (Spot + Financing) - Dividends

Another way we can do it is by calculating the implicit financing in the value of the roll. That formula looks like this:

Implicit Financing = (360/Day Between Nearby & Deferred Contract)*([Roll Price+Dividend]/[Nearby Future Price+Nearby Dividend]) Let’s look at this formula using a real world example.

Calculating Implicit Financing Using E-mini S&Ps

Let’s say that the E-mini S&Ps (/ES) are trading at 1936.75 and we want to figure out if the roll into the deferred contract is rich or not.

Assume the following information:

• The roll (front month price-deferred month price) is trading at -8.80 points
  

• There are 91 days between the nearby and deferred futures contract expiration dates
  

• There are an estimated 10.36 points in dividends accrued between expirations
  

  Let’s plug in the values given to the formula to get the implicit financing.

(360/91)*([-8.80+10.36]/[1936.75+10.36]) = .00467 or .467%.

Now that we know the implied financing rate (.467%), we can compare it to the current financing rates (we use LIBOR) to determine if the roll is trading richer or cheaper.

If implicit financing < prevailing rate (LIBOR), then the roll is cheap. If implicit financing > prevailing rate, then the roll is rich.

The current LIBOR is .30% so if we compare that to the implicit finance rate of .467%, then we know that the roll is trading rich. This signals to us that it may be a more opportune time to ‘sell the roll’ by selling the deferred contracts and buying nearby futures.

Strategies: N/A
Products Discussed In This Episode: /ES