The Myth of Roll Yield

The basic premise of this myth is that contango buyers lose money and backwardation buyers make money.More generally: curve shape is destiny! (Italics denotes it’s wrong.)

                                                                          

Before going any further, I cannot say how many times this myth is repeated; most recently today online (Indexuniverse.com), in industry and academic research but then again, I cannot say how many times this is dead wrong! NO NO NO, there is NO (and cannot BE) any such thing as roll yield, negative or otherwise.  Simply put, rolling is not a yield event, so it cannot create yield of any kind. Secondly, the theory is misunderstood.

First, it’s not a yield event. 

Let’s do the math.

Suppose, today, you are long the Jan 2013 crude oil contract at an $85.22 cost, roll out at $88.28 and roll into the Dec 2013 contract at $91.84. What is your roll yield, ahem, return? Here’s what your roll numbers are:

Jan crude: sell price 88.28 – 85.22 cost = $3.03 profit

Dec crude: sell price unknown – 91.84 cost = ???

Ok, you bought the Dec, and you paid 4% more for it than the Jan, well, so what.  All you did was establish a new basis with your roll and you have no idea where you will be selling it and what your “roll yield” is.  That’s the simple falsehood of “roll yield”.

Now to the theory.

Does the higher Dec price mean you will lose money? No.

Does the higher Dec price have anything to do with the Jan price? Well maybe and maybe not and that takes us to Arbitrage Theory.

Arbitrage theory says that the Jan price plus the cost of carry should equal the Dec price.  There should be no difference between taking delivery now and paying carrying costs versus paying for future delivery.  If there was a difference, you could make riskless arbitrage profits either way. That is theory.  In fact, spreads depend on much more than cost of carry (which deserves another post). Anyway, cost of carry is not the idea behind roll yield.

The idea behind roll yield is “convergence to spot”.  

This says that the futures price necessarily converges to the spot price over time. It seems simple, buying and holding a back month contract will eventually become a front month contract with the front month price.  So, what IS wrong with this theory? People who talk about roll yield miss the important distinction that futures prices converge to the EXPECTED spot and not today’s observable spot. 

Example:

Today’s Spot Price = Jan contract price = $88.28

Today’s Futures Price = Dec contract price = $91.84
Spot price expected on the last trading date of the Dec contract = ?

It is a wild and baseless trading maneuver to ASSUME that the expected spot will have any relation to today’s spot. You cannot use today’s spot to make an assumption about tomorrow’s spot or next month’s or next year’s!  If you try it, you will be wrong and, therein, since so many seem to (you’ll be amazed by a  “roll yield” google search), there is a potential source of market inefficiency and return!

Finally, empirical data do not support the “contango means losses” and “backwardation means gains” theory.  In fact, the most bullish markets of the last twenty years, gold and silver, are ALWAYS in contango. Backwardation was a part of certain energy markets but not so much today.   Backwardation may be a short term market aberration due to an unexpected supply interruption (crop failure) or markets with high shutdown costs (like natural gas fired power plants). 

So why so much belief in the myth?  I can only speculate that some commodity players with very poor performance seem to use contango, over and over again, as an excuse for their poor performance rather than their flawed decisions. This is just a speculation.