Roll Yield - Definition
Roll yield is the resultant profit or loss at the moment of rolling a futures contract forward with the underlying asset remaining stagnant.
Roll Yield - Introduction
Roll Yield is one of the most overlooked aspect of futures trading and is one of those things futures traders start looking into only after having traded futures for a significant period of time. In fact, roll yield could even lead to unexpected losses even with the underlying asset remaining stagnant. This is why it is important to be aware of the concept of roll yield early in your futures trading career.
In a nutshell, Roll Yield is the profit or loss that a futures contract suffers due to backwardation or contango upon expiration with the underlying asset remaining stagnant.
What Exactly Is Roll Yield?
Roll yield is an extremely hot topic of discussion and analysis in commodities futures such as crude oil futures. In such commodities, the effects of roll yield can be so severe that it can literally determine if you are a winner or a loser. This is why it is important for all futures traders, not only outright contract traders, to be aware of and consider the effects of roll yield before deciding on a futures trade. So, what exactly is Roll Yield?
Have you ever went into an outright futures trade, held it all the way to expiration and was surprised by a profit or loss even though the price of the underlying asset never moved? That profit or loss that occurred is "Roll Yield". The term "Roll" in roll yield refers to the period near or at expiration of a futures contract when futures traders typically "Roll Forward" their futures positions. A "Positive Roll Yield" is when a profit results and a "Negative Roll Yield" is when a loss results. In fact, there are futures strategies designed especially to take advantage of roll yield which can sometimes be predictable in some futures markets.
Roll yield is particularly important to take note of when you trade outright long positions for the long term, holding each contract all the way to expiration and rolling them forward. If you don't trade on such long holding periods, roll yield would not be too much of a concern to you especially if you are a day trader who closes your positions at the end of each trading day.
Positive Roll Yield & Negative Roll Yield
Why Does Roll Yield Occur?
Have you ever noticed that futures prices are almost always either higher or lower than the spot price of the underlying asset when there is still significant time to expiration? Yes, futures prices are almost always either higher or lower than the spot price due to carrying costs as well as other factors of demand and supply, however, ultimately, all futures prices converge and become the same as the spot price upon maturity.
This convergence with the spot price can happen in one of two ways. It can either converge downwards towards a lower spot price or it can converge upwards towards a higher spot price. When futures prices converge upwards towards a higher spot price, a positive roll yield results and when futures prices converge downwards towards a lower spot price, a negative roll yield results.
Such convergence happens due to two futures market conditions; Backwardation and Contango. Backwardation market is one where futures prices tend to converge upwards towards a higher spot price resulting in positive roll yields and is prevalent in some commodities futures such as coffee and sugar. Contango market is one where futures prices tend to converge downwards towards a lower spot price resulting in negative roll yields and is prevalent in some commodities futures such as Barley and Cocoa. Different commodities or futures markets have different characteristics, as such, it is important to understand if the futures market you are trading is in backwardation or contango so that you know if the winds of roll yield is in your favor.
Positive Roll Yield
Positive roll yield occurs in futures trading when the price of the futures contract you went long on is lower than the spot price of the underlying asset. Veteran futures traders call this having the "wind behind your back". When you go long on such a futures contract, you win when the price of the underlying asset goes upwards, remains stagnant or even take a small drop due to the fact that the futures contract will move upwards to match the spot price of the underlying asset particularly during the final week to expiration. Professional commodities futures traders typically seek out such backwardation markets in order to go outright long with positive roll yield.
Negative Roll Yield
Negative roll yield occurs in futures trading when the price of the futures contract you went long on is higher than the spot price of the underlying asset. Veteran futures traders call this having the "wind in your face". When you go long on such futures contracts, you only win when the price of the underlying asset exceeds the price of the futures contract by expiration. This means that if the price of the underlying asset remains stagnant or rises only by a little, you would make a loss when the futures price starts to converge downwards towards the spot price of the underlying asset close to expiration.
Controversy Surrounding Roll Yield
There has been attempts to calculate "Roll Yield" and has caused quite a bit of controversy in the academics world. We shall not attempt to go into such technicalities here. What we wish to present to traders here is that this phenomena exists and is something which futures traders might want to take into consideration when trading futures contracts outright.