Understanding Roll Yield: Scenarios in Futures Markets

What is Roll Yield?

Roll yield is the return generated when you roll a futures contract from an expiring near-term contract to a longer-dated one, based on the price difference between these contracts rather than changes in the underlying asset's spot price. This concept is essential in futures markets and influences total returns alongside spot price movements and financing costs.

You can better understand roll yield by examining market conditions like contango and backwardation, which shape the futures price curve and directly impact the yield you realize when rolling contracts. For example, OPEC and energy markets often display these dynamics, affecting roll yields significantly.

Key Characteristics

Roll yield depends on the shape of the futures curve and your position in the market. Key points to note include:

• Contango: Occurs when longer-dated futures trade above near-term contracts, causing negative roll yield for long positions due to buying more expensive contracts.
• Backwardation: Happens when near-term futures trade above longer-dated ones, generating positive roll yield as you sell higher-priced expiring contracts and buy cheaper longer-dated contracts.
• Impact on Returns: Roll yield can enhance or diminish the total return of futures investments, separate from the underlying asset's price changes.
• Term Structure: The futures curve’s slope, shaped by supply-demand and costs, primarily determines roll yield outcomes.
• Volatility Influence: Products like VIX futures often show backwardation, creating consistent positive roll yield despite spot volatility.

How It Works

Roll yield arises when you sell the expiring futures contract and simultaneously buy the next contract to maintain exposure to the asset. The return from this process depends on the price gap between these contracts, not on the asset’s spot price movement.

For long positions, roll yield is positive in backwardation because you sell the near contract at a higher price and buy the next at a lower price. Conversely, in contango, roll yield is negative, as you buy the more expensive next contract. This mechanism is crucial to understand when implementing tactical asset allocation that includes futures.

Examples and Use Cases

Roll yield plays a vital role in various markets, influencing how investors and companies manage risk and exposure. Consider these scenarios:

• Energy Sector: Companies like Chevron operate in markets where crude oil futures often display contango or backwardation, impacting roll yields and profitability.
• Airlines: Firms such as Delta face fuel cost risks that can be hedged through futures, where roll yield affects the cost of maintaining hedges.
• Commodity ETFs: Investors in commodity ETFs should be aware of roll yield effects, especially in energy sectors covered in our best energy stocks guide, as prolonged contango can erode returns.
• Volatility Trading: Trading volatility futures involves navigating roll yield influenced by the VIX curve shape, often providing a positive yield despite spot price decay.

Important Considerations

When dealing with roll yield, it’s crucial to recognize that it can either add to or subtract from your returns depending on market conditions. Negative roll yield in contango markets can steadily erode gains, especially over long holding periods.

Understanding roll yield also helps you evaluate the true cost of maintaining futures positions beyond spot price changes. Integrating this knowledge with concepts like the J-curve effect can refine your investment decisions in futures and related instruments.