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..

As shown above the Reliance Infra March Futures is quoting at Rs.457.20. Now, what about the futures of Reliance Infra April Contracts?

As seen above from the NSE data, the Reliance Infra April Futures is quoting at Rs.460.40, which is at a premium to the March futures due to the cost of funding. This becomes the earning for the short roller. Now, what will the short roller do in this case?

The short roller is already short on the March futures of Reliance Infra. So, he will buy back the Reliance Infra April Futures and simultaneously sell May futures. The spread of Rs.3.20 will become the earning for the short roller.

But the short roller is still holding to the cash position of arbitrage..

His cash buying at Rs.440 is still intact and that will not be touched. What the arbitrageur will do is to just roll over the Reliance Infra short futures into the next month. So, what is his yield realized?

Realized short roll yield = (460.40-457.20) / 457.20 = 3.20 / 457.20

Reliance short roll yield = 0.00699 or 0.70% for one month

So the arbitrageur will hold on to his cash market position and roll over his short position in futures at a positive yield of 0.70%. This will, in turn, become the cost of the long roller of the futures.

In the above case the annualized yield on the short roll will be 8.72%. However, it needs to be remembered that monthly short roll spreads will vary and hence annualizing of one month’s yield does not give the correct picture. The bottom-line is that the short roller (who is also the arbitrageur) earns the spread by holding on to his cash position and rolling over his short futures position.

Getting back to the idea of roll window..

The short roll is never done manually but is either done through the NSE roll window or through the implementation of algos. That way the short roller can define the spread that he wants to earn and the spread window will only execute if the spread of 0.70 basis points is available or better than that. The crux of the matter is that while there are speculators who also sell naked futures, the short rolling is predominantly done by arbitrageurs.

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