What it means
Futures contracts exist for a series of future delivery dates, so at any moment a commodity might have contracts expiring in each of the next twelve months. The front month is simply the closest of those, sometimes called the spot month or the nearby contract.
It matters because liquidity concentrates there. Tight spreads and deep order books make the front month the cheapest place to trade, which is why hedgers and speculators cluster in it, and why it is used as the reference price in commentary and in many commercial contracts.
The complication is that the front month expires. Anyone who wants continuous exposure must sell the expiring contract and buy the next one, a routine operation called rolling, and the price difference between the two contracts becomes a real gain or cost each time it happens.
If the further-dated contract is more expensive, the market is in contango and rolling costs money. If it is cheaper, the market is in backwardation and rolling earns money.
Over a year of monthly rolls, this can matter more to a commodity investor's return than the direction of the commodity price itself. There is also a practical hazard near expiry.
Once the contract passes its first notice day, a holder can be obliged to make or take physical delivery, which is why commercial users set hard internal deadlines to be out of the front month well before that point.
In practice
Real-world examples.
Example
An airline hedging jet fuel buys front-month contracts and rolls them monthly to keep continuous cover. Its treasury team tracks the roll separately from the fuel price, because the hedge can cost money even in a month when fuel prices do not move.
Example
A natural gas trader holds 10 contracts of 10,000 MMBtu each, with the front month at $3.20 and the next month at $3.35. Rolling costs $0.15 x 10,000 x 10 = $15,000, a figure the desk compares against the cost of simply buying a longer-dated contract instead.
Example
A coffee roaster is long 4 contracts of 37,500 lb each in a backwardated market, with the front month at $1.85 a pound and the next month at $1.80. Rolling earns $0.05 x 150,000 lb = $7,500, a positive roll yield that partly offsets the cost of holding the hedge.
Formula
Calculation
Roll Cost per Unit = Next Month Price - Front Month Price
Total Roll Cost = Roll Cost per Unit x Contract Size x Number of Contracts
A fund holds 20 crude oil futures contracts, each covering 1,000 barrels. The front month is trading at $78.40 a barrel and the next month is at $79.60.
Roll cost per barrel = $79.60 - $78.40 = $1.20. Total roll cost = $1.20 x 1,000 barrels x 20 contracts = $24,000.
As a percentage of the front-month price that is $1.20 / $78.40 x 100 = 1.53% for one month. If the same shape persisted for a year of monthly rolls, the drag would be roughly 1.53% x 12 = 18.4%, which is why a commodity fund can lose money in a year when the commodity price itself finished flat.Case study
Seen in the real world.
Meridian Grain Trading is a fictional firm used purely to illustrate how front-month mechanics catch people out. It held 50 corn futures contracts of 5,000 bushels each as a hedge against a forward sales book, and treated the position as if it were a simple long-term investment.
Ten days before first notice day the clearing broker called to confirm delivery arrangements for 50 x 5,000 = 250,000 bushels of physical corn, which Meridian had no elevator space to receive. The firm rolled in a hurry into the next contract, paying a spread of $0.12 a bushel, or $0.12 x 5,000 x 50 = $30,000, on top of wider spreads caused by trading under time pressure.
The illustrative fix was procedural rather than clever. Meridian added first notice dates to its treasury calendar with a hard rule to be out of the front month at least fifteen business days early, and it began quoting the roll cost as a separate line in its monthly hedging report so that nobody could mistake it for zero again.
Watch out
Common mistakes.
- Assuming the front-month price is the price you can lock in for a year, when longer-dated contracts often trade at meaningfully different levels.
- Forgetting that the front month expires, and drifting past first notice day into an obligation to take physical delivery.
- Ignoring roll cost when comparing a commodity fund's return with the headline commodity price, which makes the fund look inexplicably poor.
Questions
People also ask.
What is the difference between the front month and the spot price?
The spot price is for immediate delivery today, while the front month is the nearest futures contract, so the two are close but not identical.
Why is the front month the most liquid?
Because hedgers and traders concentrate where uncertainty is lowest and spreads are tightest, which is a self-reinforcing effect near-term.
Can I avoid rolling altogether?
Yes, by buying a longer-dated contract, though you accept wider spreads and thinner liquidity in exchange for fewer roll transactions.
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