Understanding Roll Forward
Let me explain what roll forward means in trading. It 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.
You use a roll forward to maintain your position beyond the initial expiration of the contract, since options and futures have finite dates. I usually carry this out shortly before the initial contract expires, and it requires settling the gain or loss on the original contract.
Basics of Roll Forward
A roll forward involves two steps: first, you exit the initial contract, then you initiate a new position with a later expiry. You should execute these steps simultaneously to reduce slippage or profit erosion from changes in the underlying asset's price.
The procedure, or 'switch,' varies depending on the financial instrument you're dealing with.
Key Takeaways
- Roll forward extends a derivatives contract by closing a soon-to-expire one and opening another at the current market price for the same underlying asset with a future closing date.
- Common derivatives for roll-forwards include options, futures contracts, and forwards.
Roll Forward for Options
For options, you can roll forward using the same strike price for the new contract or set a new one. If the new contract has a higher strike price, it's a 'roll up'; if lower, it's a 'roll down.' These help protect profits or hedge losses.
Take this example: suppose you have a call option expiring in June with a $10 strike on Widget Company, and the stock is at $12. If you're still bullish as expiration nears, you can sell the June call or buy a September call with a $12 strike. This roll up reduces the premium for the second option, protecting some profits from the first trade.
Roll Forward for Forwards
Forward foreign exchange contracts get rolled when the maturity date becomes the spot date. For instance, if you've bought euros versus the U.S. dollar at 1.0500 for June 30, you'd roll on June 28 via a swap. If the spot rate is 1.1050, you sell the euros at that rate, receive the profit in dollars on June 30.
The euros net to zero without fund movement. You then enter a new forward to buy the same euros at the 1.1050 spot rate plus or minus forward points to the new date.
Roll Forward for Futures
You must close a futures position before the First Notice Day for physically delivered contracts or the Last Trading Day for cash-settled ones. Usually, you close for cash and enter the same futures trade with a later expiry.
For example, if you're long a crude oil future at $110 expiring in June, close it before expiry and enter a new contract at the current rate with a later date.
Fast Fact
Remember, this information isn't tax, investment, or financial advice. It's presented without considering your objectives, risk tolerance, or circumstances, and it might not suit you. Investing risks loss of principal.
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