Roll forward refers to extending the expiration or maturity of an option, futures contract, or forward by closing the initial contract and opening a new longer-term contract for the same underlying asset at the then-current market price. This enables the trader to maintain the position beyond the initial expiration of the contract, as options and futures contracts have finite expiration dates. It is usually performed shortly before the expiration of the initial contract and requires that the gain or loss on the original contract be settled.
Mastering the Basics of Roll Forward
A roll forward includes two crucial steps. First, the initial contract is exited. Next, a new position with a later expiry is initiated. These two steps are usually performed simultaneously to minimize slippage or profit erosion due to a change in the price of the underlying asset.
The roll forward procedure or “switch” varies for different financial instruments.
Key Takeaways
- Roll forward refers to the extension of a derivatives contract by closing out a soon-to-expire contract and opening another one at the current market price for the same underlying asset with a future closing date.
- Commonly used derivatives in roll-forwards include options, futures contracts, and forwards.
Roll Forward with Options
A roll forward can be done using the same strike price for the new contract as the old one, or a new strike can be set. If the new contract has a higher strike price than the initial contract, the strategy is called a “roll up,” but if the new contract has a lower strike price, it is called a “roll down.” These strategies can be used to protect profits or hedge against losses.
For example, consider a trader holding a call option expiring in June with a $10 strike price on Widget Company. The stock is trading at $12. As the call option nears expiration and the trader remains bullish on Widget Company, they can choose to maintain their investment stance and protect profits by either selling the June call option or simultaneously buying a call option expiring in September with a strike price of $12. This “roll up” to a higher strike price will reduce the premium paid for the second option, thereby preserving part of the profits from the first trade.
Roll Forward for Forwards
Forward foreign exchange contracts are usually rolled forward when the maturity date becomes the spot date. For instance, if an investor has bought euros versus the U.S. dollar at 1.0500 for value on June 30, the contract would be rolled on June 28 by entering into a swap. If the spot rate in the market is 1.1050, the investor would sell the equivalent number of euros at that rate and receive the profit in dollars on June 30.
The euros would net to zero with no exchange of funds. The investor would simultaneously enter into a new forward contract to buy the same amount of euros for the new forward value date; the rate would be the same 1.1050 spot rate plus or minus the forward points to the new value date.
Roll Forward in Futures
A futures position must be closed out either before the First Notice Day, in the case of physically delivered contracts, or before the Last Trading Day, in the case of cash-settled contracts. The contract is typically closed for cash, and the investor simultaneously enters into the same futures contract trade with a later expiry date.
For example, if a trader is long a crude oil future at $110 with a June expiry, they would close this trade before it expires and then enter into a new crude oil contract at the current market rate that expires at a later date.
Conclusion
Utilizing roll forward strategies can significantly enhance a trader’s ability to maintain positions and manage profits effectively. Whether dealing with options, forwards, or futures, understanding and executing roll forward techniques can provide an edge in the competitive world of trading.
Related Terms: Strike Price, Hedge, Call Option, Forward Contract, Swap.
