Rollover Costs in Futures Trading

 

High Interest Rates and Rollover Costs in Futures Trading

This blog post explores the concept of rollover costs in futures trading, particularly focusing on how high interest rates can impact retail investors.

High Interest and the Cost of Carry

• Needy Borrowers Pay More: When interest rates are high, borrowing money becomes more expensive. This applies to futures contracts as well. Investors who hold onto a futures contract beyond its expiry (rollover) incur an interest charge.
• Cost of Carry: The cost of carry refers to the difference between the spot price (current market price) of an underlying asset and the futures price. A positive cost of carry indicates higher futures prices compared to the spot price.

Psychology of High Rollover Costs

• Retail Investor Behavior: Generally, retail investors tend to buy first and sell later. This can lead them to hold onto losing positions in the hope of a price reversal.
• Carrying Forward Losses: To avoid squaring off a losing position at expiry, some retailers choose to rollover the contract, even with high interest charges. They believe the price will move in their favor in the next contract cycle.

Example: Nifty Futures Rollover

• Normal Interest: We'll assume a typical interest rate of 0.4% (based on a yearly rate of 10% divided by 12 months).
• Normal Rollover Cost: This translates to a cost of around ₹70 for a Nifty future priced at ₹17,512.
• Scenario 1 - Normal Market: If the next month's Nifty future price is ₹17,582 (spot price + rollover cost), the market behaves normally, and there's likely no significant buying or selling pressure.
• Scenario 2 - High Rollover Cost: Let's say the next month's Nifty future is priced at ₹17,650. This higher cost indicates potential demand or a situation where many retailers are stuck in losing positions and willing to pay a premium to rollover.

Interpreting Rollover Costs

• 0.40% - 0.60%: This range signifies a normal market environment.
• 0.70% - 0.75%: This indicates a potentially risky situation. Smart money might exploit the situation by driving prices down, knowing retailers are trapped in long positions. Historically, there's a higher chance of price falls in this range.
• 0.80% - 0.85%: This is a very risky scenario. Based on past data, there's a high probability of significant price drops (around 300-500 points) in the Nifty over the next 15 days.

Discount in Futures Price

• Discount and Dividends: Sometimes, the futures price might be lower than the spot price (discount). This can happen due to upcoming dividend payouts on the underlying stocks in the Nifty index. In such cases, rollovers from April to May contracts are typically ignored.
• Shorts Trapped in Discount: A discount not due to dividends suggests retail investors might have shorted the Nifty (selling futures expecting a price decline). This could signal an upcoming price rise (300-500 points) over the next 15 days, presenting a good buying opportunity.

Case Studies: Nifty Futures Rollover

• March 26th & 27th, 2024: The cost of carry remained around 0.38% despite a falling market. This suggests smart money might be accumulating Nifty futures, anticipating a reversal.

Key Takeaways

• High rollover costs can indicate retail investor struggles and potential price declines.
• Understanding rollover costs helps identify potential trading opportunities.
• Analyze only the last two days of expiry data for the most relevant insights.
• Similar effects can be observed in other indices like Bank Nifty, with potential price movements of 600-1000 points.

Understanding Roll Costs and Their Impact

This explanation dives into the concept of roll costs in futures trading, particularly focusing on the Indian Nifty 50 index. It explores how interpreting roll costs can offer valuable insights for traders.

Roll Cost: The Price of Carrying Forward

• Interest and Carrying Costs: When holding a futures contract beyond its expiry date (rolling over), you incur an interest charge. This cost, along with any storage or dividend fees (if applicable), is collectively known as the cost of carry.
• Spot vs. Futures Price: The cost of carry is influenced by the difference between the spot price (current market price) of the underlying asset and the futures price. A positive cost of carry indicates higher futures prices compared to the spot price.

Interpreting Roll Costs for Strategic Decisions

• Normal Range (0.40% - 0.60%) signifies a balanced market environment.
• Risky Zone (0.70% - 0.75%) suggests potential trouble for longs (those holding buy positions). Smart money might exploit this by driving prices down, as many retailers are likely stuck in long positions. Historically, there's a higher chance of price falls in this range.
• Very Risky Zone (0.80% - 0.85%) indicates a situation where a significant price drop (around 300-500 points in Nifty) is highly probable over the next 15 days, based on past data.

Discount in Futures Price and Underlying Psychology

• Discount and Dividends: Sometimes, the futures price might be lower than the spot price (discount). This can happen due to upcoming dividend payouts on the underlying stocks in the Nifty index. In such cases, rollovers from April to May contracts are typically ignored due to the impact of dividends.
• Shorted Nifty? Potential Upside: A discount not due to dividends suggests retail investors might have shorted the Nifty (selling futures expecting a price decline). This could signal an upcoming price rise (300-500 points) over the next 15 days, presenting a potential buying opportunity.

Important Considerations

• Focus on Recent Data: Analyze only the last two days of expiry data for the most relevant insights. Data from months ago might not reflect current market conditions.
• Similar Effects in Other Indices: Similar patterns can be observed in other indices like Bank Nifty, with potential price movements based on roll costs.  
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• Roll cost and is effect
  
  
  How to read Roll cost
  
  
  ►0.20 -0 .40 Normal.. In the current market scenario since 2023  where 0.30 -0.50 is becoming normal
  
  
  ► We see below these levels, the best are negative Roll cost
  
  
  ► Or we see above 0.50, good at 0.75 and above and best at 0.85 or above
  
  
  ► Generally said that low or negative Roll cost means shorts are trapped so nifty may go up
  
  
  ► Generally said that high Roll cost means longs are trapped so nifty may fall
  
  
  ► Never see April to May due to dividends in Nifty stocks.

Remember: This information is for educational purposes only and should not be considered financial advice. Always conduct your own research before making any trading decisions.

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