What it means
Many commodity and volatility indices are built from futures contracts rather than the physical goods. A futures contract is an agreement to buy or sell something at a set price on a future date, and it eventually expires.
To avoid taking delivery, the index provider sells the contract that is about to expire and buys a later one. This switch, called the roll, usually takes place over a fixed window of days each month so the trading is spread out and the market is not overwhelmed.
The price gap between the two contracts decides whether rolling helps or hurts. In contango, the later contract is more expensive, so selling the near one and buying the far one costs money and drags on returns.
In backwardation, the later contract is cheaper, so the roll adds to returns. Investors in funds that track these indices feel the effect directly.
The roll return can be positive or negative and can add up to a large part of the long-term result, which is why a fund can lag a rise in the spot price of a commodity. Traders watch the roll window closely, because the heavy buying and selling by tracking funds can move prices temporarily.
Anyone holding a rolling position should check the index rules to see exactly which contracts are held and when they change. Funds that track the index often hold the position for years, so a small roll cost can compound into a large gap against the spot price.
Some products try to reduce the drag by rolling into contracts further out, or by choosing the contract with the cheapest roll, but each approach has its own trade-offs and costs.
In practice
Real-world examples.
Example
A commodity exchange-traded fund tracks an oil futures index. At the monthly roll it sells the expiring contract and buys the next one, and the fund's manager explains to investors why the fund's return differs from the oil spot price.
Example
A hedge fund trader expects heavy index-tracking flows during the roll window for a major equity futures index. She trades ahead of the roll to capture the small price pressure that usually follows.
Example
A corporate treasurer uses a rolling futures hedge on jet fuel. Each quarter she moves the hedge to the next contract, and she includes the expected roll cost in the annual fuel budget. That way the board sees the true cost of the hedge before the year begins, not after.
Formula
Calculation
Roll cost (in contango) = (Price of next contract - Price of expiring contract) / Price of expiring contract
A commodity index holds the near-month contract at $80 and rolls into the next-month contract at $82. The roll cost is (82 - 80) / 80 = 2 / 80 = 2.5%. If the index rolls every month and the gap stays the same, the drag is roughly 2.5% x 12 = 30% a year, ignoring compounding. Holding $1,000,000 in the index, the cost of one monthly roll is 1,000,000 x 2.5% = $25,000.Case study
Seen in the real world.
Summit Grain Fund is an illustrative, fictional commodity fund that tracks an index of wheat futures. Over one year the spot price of wheat rose by 4%, yet the fund's investors earned a loss of 6%.
The fund's manager explained that the wheat market had been in contango all year, with each later contract priced about 1% above the one expiring. Rolling twelve times meant paying that premium repeatedly, which cost roughly 10% of value over the year.
The fictional investors had not understood that they owned a rolling position, not the grain itself. The illustrative lesson is that the roll is a real and often substantial source of return that must be considered before buying such products. Reading the fund's factsheet for the roll method would have shown the risk in advance.
Watch out
Common mistakes.
- Assuming a futures-based fund follows the spot price of the commodity, when roll costs or gains can make the results very different.
- Believing the roll is a one-off event, when it recurs on a fixed schedule and affects returns every period.
- Ignoring the roll window when trading around index events, as heavy volume can move prices briefly and widen costs.
Questions
People also ask.
What is the difference between contango and backwardation?
Contango means later contracts cost more than nearer ones, which hurts a rolling long position, while backwardation means later contracts cost less, which helps it.
Who decides when an index rolls?
The index provider publishes the roll schedule and rules in advance, so funds and traders know the exact days.
Can the roll return be positive?
Yes, when the market is in backwardation the investor sells high and buys low at each roll, which adds to returns.
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