If long rolling of futures refers to the carrying over of long positions to the next month then short rolling of futures refers to the rolling over of short positions in futures to the next month. If the long roller pays a spread for long rolling, which is his cost; the short roller receives the spread which is his income for the short position. But there is a fundamental difference between the nature of the long roller and the short roller. The long roller is normally a directional position while the short roll belongs to an arbitrage position.
Let us understand roll over forward contract example. Also let us understand the futures rollover price difference. It is important to know how to calculate rollover cost and how to annualize it. Let us grasp the arbitrage position and how short roll fits into the same.
How an arbitrage position rolls over short futures?
What is arbitrage in the cash-futures market? What conservative traders do is to buy in the cash market and simultaneously sell in the futures market to lock in the spread. Here is how the arbitrage position looks like..
Cash positionFutures PositionSpread locked inArbitrage Yield (%)Bought RIL in spot at price of Rs.950Sold RIL Mar Futures at price of Rs.958Rs.8 (958 – 950)(958-950) / 950 = 0.0084 or 0.84%
The monthly arbitrage yield is 0.84%. So what is the annualized yield on arbitrage?
Annualized yield = [(1+monthly yield) 12 – 1
Annualized yield = 10.56%
In the above arbitrage transaction, the locked in assured yield is 10.56% annualized. But how do you realize this yield?
Realizing the arbitrage yield in reality..
In the above instance, you have locked in the monthly yield of 0.84% and an annualized yield of 10.56%. There are 3 ways by which the arbitrage yield can be actually realized..
In the first case, the arbitrage yield can be realized on the date of settlement. On the settlement date the futures price and the spot price will converge at close to 0. If the cash market position is unwound and the futures are left to expiry, the locked in yield can be realized.
Alternatively, the trader can look at ways to realize the yield when the spread comes down sharply. For example, if the spread comes down from 0.84% to 0.10% in a few days due to heightened volatility, the transaction can be closed and the difference between the spreads can be realized.
In both the above cases, there is a capital gains implication when cash market positions are unwound. That is why most traders avoid that strategy, unless it is extremely profitable. The third, and most common option, is to roll over the short futures position. By rolling over the short futures positions (which is normally at a premium), the positive spread can be earned by the short roller.
How does the short roller earn the spread on roll over?
Let us take the case of Reliance Infrastructure. Assume that the arbitrageur is holding on to a position on Reliance Infra that he has purchased at Rs.440 and sold the March Futures at a price of Rs.444 and locking in a monthly spread of 0.91%. Now let us consider the current price of Reliance Infrastructure March futures and April Futures as under..
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