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Rollovers and contract expiration are some of the most confusing terms for retail traders. It is vital to understand what these are and what implications they might have for your trading. You can avoid being caught out and losing money if you understand rollover. So, what are futures contracts and how does rollover work?

 

What is a Futures Contract?

Let’s start from the beginning. To understand rollover you have to first understand the futures markets. A futures contract is an agreement between a producer and an investor, for the purpose of avoiding market volatility. This contract fixes the price of the deal, for delivery of the goods on a specified date in the future (hence futures contract). In order for sustainable production, the producers need a relatively stable income and that is why these fixed price contracts are agreed.

The key is that the investor takes both the risk and the reward of the volatile market. This means if the price of the asset drops, the investor is paying over-market for the goods; whereas if the price of the asset rises, the investor is paying under-market for the goods.

Let’s look at an example:

A coffee farm (the producer) sells coffee beans at $4 to an investor. They agree on this price after some negotiation; the producer is making a good profit and the investor is happy with the value they are receiving as well as the risk they are taking. If the price of coffee then drops below a certain rate, the investor is contractually obliged to pay the difference to the farmer (i.e still pays $4 even though the market price is $3 for example). If the price of coffee climbs above a certain price, the investor gets to keep the profits (i.e still pays $4, even though the market price is now $6).

What is a Futures Market?

The futures market is where participants can buy and sell these contracts for delivery on a specified date in the future. For the participants, this also locks in the price and therefore offsets the market volatility. However, as we saw recently on the Oil market, the expiration of contracts can cause panic if there is insufficient liquidity in the market! The delivery date or expiration date of these contracts is usually a monthly or quarterly occurrence; depending on the market instrument (e.g Crude Oil has a monthly rollover).

End-Users vs. Traders:

The two key players in futures markets are End-Users and Traders. The end-user is someone, usually representing a company, who wants to purchase and use the physical asset. For the coffee bean example, companies like Nescafe would be an End-User since they want to use the coffee beans to create their coffee. Traders, however, have no intention of taking delivery of the asset. These traders, often representing hedge funds and trading sizeable accounts, are using the volatility of the market to profit from buying and selling these contracts.

Before the expiration of the contract, traders will look to liquidate (sell-off) or rollover their futures holdings. This is because they do not have the storage or infrastructure to actually take delivery of the asset. Normally rollover is relatively straightforward and cheap to do, when the price difference between the expiring contract and the new contract is small. However, as we saw recently with crude oil (Oil WTI on our broker), there was a significant gap between the prices which made the cost of rollover very unattractive to traders.

How does rollover work for retail traders?

You, like me, are likely classified as a retail trader. This means someone who trades via a brokerage firm or investment account and trades in relatively small amounts compared to institutional investors. Due to the way online brokers function, they manage the rollover of futures contracts so that the traders do not have to worry about it. The broker rolls over the contract in advance of expiration; subject to their rollover table. This enables retail traders to keep positions open when the contract switches.

What are “swap points”?

To account for the difference in price when a futures contract rolls over, the broker gives out “swap points”. If you had a buy position and the price gaps up because of the rollover, the difference in price is taken from your trade as negative swap points equal to the amount your trade ‘artificially’ profited. If you had a sell position and the price gaps up because of the rollover, the difference in price is added to your trade as positive swap points equal to the amount your trade ‘artificially’ lost.

IMPORTANT NOTE:

Since brokers usually have a ‘market execution’ policy, any stop losses, take profits or limit orders that are surpassed by the rollover gap will be executed as normal. This could result in your trade being stopped out early. Stop losses, take profits and orders do NOT automatically adjust when the contract rolls over.

How can you reduce your risk?

Firstly, make sure you’re aware of when a rollover might happen. There are only a few futures markets on our broker; these include Oil, Natural Gas and the soft commodities like Cocoa, Soybeans etc. Take note of the dates of the rollover. Make sure that you have either closed out positions or moved stop losses, take profits and orders. I recommend closing the position before rollover and reopening at the new price to avoid any mistakes.

Does rollover affect indicators?

Yes. Since there is a gap in the market caused by the contract rollover rather than normal price action, indicators like moving averages will be affected by it and skewed. This is something you just have to be aware of. Although initially the indicator may jump, after a few days it would usually average out and once more be representative of the price action. Obviously if your moving average is over a shorter time-frame then it will be more affected by the rollover gap.

In summary:

Rollover occurs when futures contracts expire and roll over to the next period. Futures contracts are agreements to fix the price of an asset for the benefit of the producer. These contracts are traded on the futures market. As a retail trader your trade is automatically rolled by the broker, and swap points are awarded as appropriate. To avoid undesired close-out or opening of trades, make sure you know when rollover is going to happen.

 

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