How and Why Do Futures Contracts Rollover?
Of the many things that makes futures trading uniquely different to other markets such as over-the-counter traded spot forex or stocks is the concept or rollovers or expiration. Unlike stocks or spot markets where the instrument can be traded and held in perpetuity, futures contracts and other derivative instruments come with what is known as a rollover. The terms rollover and/or expiration are often used interchangeably and are in a way related to one another.
In the world of futures trading, “Rollover” refers to the process of closing out all option positions in soon-to-expire futures contracts and opening new contracts in newly opened futures contracts. The concept or rollover is unique to different futures contracts covering the markets and the rollover has a significant impact on the contract and the market’s volatility, prices and volume.
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Not all futures rollovers happen at the same time and therefore futures day traders need to keep a close eye on the rollover dates of the contracts that they are trading. Usually, the days leading up to the futures contract’s rollover date is important from a risk management standpoint and duly deserves full attention of the investors who are engaged in trading the particular contract. The closer it gets to a contract’s expiry or rollover, the bigger the challenges that come with it. Rollover in futures is a key aspect that needs to be accounted for and there is no way to getting around it, unless you keep your trading to the active trading periods within the active monthly or quarterly contract that you trade.
When trading futures, day traders are typically better positioned to close out their trades once the contract gets closer to the last trading day. In most cases, your futures broker will automatically close out the position. However it is in your best interest not to let that happen but instead focus on managing and closing out your positions before the expiration date or the last trading date.
Every futures trader should clearly understand what rollover is in futures trading as failure to ignore this rather simple feature of the futures markets can result in premature closing out on positions. While it wouldn't matter if your trades were running in profit, a trade closure on account of a rollover and one that is running at a loss can prove to be expensive.
In this article we take a look at what are the futures contracts rollovers and why they take place.
Why do futures contracts have a rollover?
Futures contracts, as you might know are derivatives which track the prices of the underlying market. A futures contract is simply a hedging tool where a buyer and seller agree to buy or sell certain number of units in a commodity or an asset at a certain price for a future date of delivery. Most traders in the futures markets today typically use it to hedge against market exposure, so most of the trading is done for speculative purposes only rather than taking physical delivery of the asset.
Therefore, futures contracts need to be rolled over into the next contract month to avoid taking delivery or being obliged to deliver the underlying asset or commodity.
Physical settlement of futures contracts
The physically settled futures contracts are one of the two ways how futures contracts are settled upon expiry. Physically settled futures contracts are more prominent in non-financial markets or commodity markets in general. These include, grains, livestock, precious metals etc. where there is an underlying commodity. After the futures contract expires, it is generally the job of the clearinghouse to match the holder of the long contract and the holder of the short contract. The trader holding the short contract is required to deliver the underlying asset to the holder of the long contract. To make the exchange, the holder of the long contract must place the entire value of the contract with the clearinghouse in order take delivery of the asset. This can be a costly affair and can vary from one market to another. For example, one contract of crude oil controls 1000 barrels of oil. At a price of $50 per barrel, the holder of the long contract must deposit $50 x 1000, $50,000 with the clearinghouse to take delivery. On top of this, there are additional costs of storage and delivery that the buyer must pay for.
As you can see from the above, taking physical delivery of a commodity can be expensive unless you really know what you are doing.
Cash settled futures contracts
Cash settled futures contract, as the name suggests is settled for cash instead of physical delivery. Many financial futures contracts fall under this category with the most famous and popular contracts such as the emini equity index contracts (S&P500, Dow, Nasdaq). The cash settled futures contracts are settled for cash after expiry meaning that after the last trading day for the futures contract, the prices are marked to market and the futures trader’s account is either debited or credit depending on whether the trader was long or short and if it resulted in a profit or a loss.
What is Expiration and Roll Date in futures contract?
A futures contract is finite in its duration and therefore every futures contract comes with key specifications that traders need to be aware of.
- Last trading day is the date when you can trade the futures contract (open/close/modify your position). After the last trading day all positions are set to 'close only' mode.
- Expiration day is the date that a futures contract is binding for. After expiration the contract is no longer valid.
- Expiration hour is the hour when a futures contract expires. In most cases this is during the last trading hour of the expiration day.
There is usually a few days gap between the last trading day and the expiration day, this is known as the roll date. It is during these days that volatile picks up and also you might start getting alerts from your futures broker to close out your open trades.
Roll dates are unique to each contract and can vary in duration. Therefore futures traders need to bear in mind about this important variable. As an example, the roll date for the emini S&P500 futures is around eight days prior to expiration date.
While expiration date and last trading day are fixed, the roll dates can vary. It is essential to understand this major distinction as traders often confuse roll dates for expiration dates.
The period of roll date is one of the most volatile periods as it marks the end of the current contract and the beginning of a new contract. Therefore, volumes will start to shift significantly as traders start closing out the positions on the existing contracts and open new positions in the fresh or the front month contracts. Price volatility can be seen in both the contract periods.
It goes without saying that traders who trade a contract during the roll dates will find it difficult to manage their traders and traders should also expect to see slippage in prices.
Trading volumes during these periods are typically split between the expiring contract and the new contracts leading to large price swings and gaps. The roll dates influence not just volumes but can also lead to higher spreads which makes it difficult to enter or exit from a day trading position.
The volatility also increases the risk of slippage as day traders are likely to get bad fills which could eventually end up costing more than any profits you thought you could make.
Witching days and Futures Contract Expiry
You might have heard of the term triple witching and quadruple witching. While it has got nothing to do with Halloween, double, triple and quadruple witching refers to a phenomenon when different asset classes or derivates of the equity markets expire. Needless to say these periods can see high level of volatility and can lead to erratic market behavior.
Double witching takes place on the third Friday of the month, eight times a year. It is when contracts for stock index futures and stock index options expire on the same day. Double witching happens eight months in a year except in March, June, September and December.
Triple witching is a phenomenon when stock index futures, stock index options and stock options all expire on the same day. Triple witching usually takes place on the third Friday of the month. It takes place during the months of March, June, September and December; the months of the year when double witching doesn’t take place. Quadruple witching is similar to triple witching except that in addition to the three asset classes that expire, even the single stock futures tend to expire on the same day. Quadruple witching also takes place four times a year during March, June, September and December and happens on the third Friday of the months.
The period surrounding the roll dates are often challenging times for traders and therefore extra caution needs to be applied when the roll dates are in effect for a contract.
Day traders are also better off to stay away from the markets unless you prefer to the volatility that comes during the last days of a contract’s expiry and the initial days of a new contract opening period. In all other cases, it is prudent to stay away from the markets until the full new front month contract takes over and volatility and volumes are adjusted and become more stable.
Futures rollovers are nothing to be feared about and it takes a bit of practice in order for professional futures day traders to trade closer to or in the early days of an old or a new futures contract month. In most cases your futures broker will send you multiple alerts in the weeks and days leading up to a contract’s expiration or last trading day and if you still continue to ignore the alerts and fail to liquidate your position, your positions are automatically closed out by the futures broker.
For futures traders who are just getting started, it is always advisable to stay aside until the dust is settled before you resume your day trading.