Understanding the rollback trading strategy: Benefits and drawbacks

Summary:

Rollback trading is a strategy where you close out an existing position and open a new one with an earlier expiration date. This can be used to reduce risk, lock in profits, or take advantage of changing market conditions. In this blog, we'll explore the benefits and drawbacks of rollback trading and give you some tips for using it effectively.

You might be familiar with the term "rollback" from software updates. When an update doesn't work as planned, the software goes back to its previous version. This concept isn't just for software; in derivatives trading, traders use a similar approach. They have a "rollback" strategy to adjust their positions when they see changes in the market. In this blog, we'll give a clear overview of the rollback trading strategy. We'll cover its different types, how traders use it, and discuss its advantages and disadvantages. By the end, you'll have a good understanding of how this strategy fits into the bigger picture of derivatives trading.

What is the rollback trading strategy?

When trading derivatives, you enter a contract that lasts until a specific date, the expiration date. As that date draws near, you might think, "I want to maintain my position in this asset, but perhaps not for the duration of my current contract." This is where the rollback strategy becomes useful. You can close your current contract and initiate a new one that concludes a bit earlier.

Types of rollbacks

There are several types of rollbacks in derivatives trading, each with its own unique purpose. Some rollbacks are used to reduce risk, while others are used to take advantage of changing market conditions. Here are some of them:

• Rollback with the same strike price:  Here, you can close your current contract and start a new one with the same terms, but at an earlier expiration date if you want to maintain your position in the asset without committing to the original contract's duration. 

• Roll up: Ideal for situations where there's optimism about the asset's price rising. You can easily close your current contract and open a new one with a higher strike price and a nearer expiration date.

• Roll down:  If you anticipate the asset's price might drop, you can transition to a new contract with a lower strike price and an earlier expiration date.

• Roll sideways: When the market's direction is unclear, you might opt to keep your position but with a different expiration. This means moving to a new contract with a similar strike price but a different expiration date.

How does the rollback strategy work?

Imagine you're a trader and you have a futures contract for Gold worth INR 10,00,000, and it ends on 31st December.

On 10th November, everything looked fine. But by 15th November, you see signs that the price of Gold might go up a lot by the end of November. You think this price rise might not last in December, and you want to make money from this short-term rise.

So, on 16th November, you decide to use the rollback strategy:

• You sell your current contract: You sell your futures contract that ends on 31st December. Let's say you get INR 10,05,000 for it, so you make a small profit.

• You buy a new contract: At the same time, you buy a new futures contract for Gold. This new contract also has a value of INR 10,00,000, but it ends on 30th November. You pay INR 10,03,000 for it.

• What could happen next: If the price of Gold goes up by 30th November as you thought, you could sell your new contract for more money, like INR 10,20,000. This means you make a good profit quickly.

But if the price of Gold doesn't go up as you thought, you might lose money. However, because you only have a contract for November, you don't have to worry about what happens in December.

Advantages of rollback trading strategy

Here are the three most critical and important benefits or pros of this strategy:

1. You can reduce risk by limiting potential losses: By closing a losing position and opening a new one with a lower strike price, the rollback strategy helps you limit potential losses, especially when the market isn't in your favour.

2. Improves liquidity for larger trades: For those trading in volume, the rollback strategy can enhance liquidity, enabling you to make larger trades without significantly impacting the market price.

3. Lock in your profits to benefit from favourable market movements: If you're seeing gains, the rollback strategy lets you secure them. Close a profitable position and start a new one with a higher strike price, ensuring you benefit from favourable market movements.

Drawbacks and challenges of the rollback strategy

The rollback strategy is a popular hedging technique, but it's not without its drawbacks. Here are three of the most important ones to be aware of: 

1. Potential for increased losses if the market doesn't swing your way: While the rollback strategy can limit losses, it's not foolproof. If the market continues to move against your predictions, you might find yourself facing even greater losses.

2. You might miss out on long-term gains: By focusing on short-term market movements, you could potentially miss out on more substantial, long-term gains that a different strategy might offer.

3. Transaction costs can accumulate: While individual transaction costs might be lower, frequently rolling back can lead to an accumulation of fees over time and eat into your potential profits.

Wrapping up: Key points to remember 

• In derivatives trading, a "rollback" lets you switch to a new contract that ends sooner if you think your current one might not be beneficial till its end date.

• This strategy can help limit losses and allow bigger trades without majorly affecting the asset's price when the market looks promising.

• However, there is a potential for bigger losses if the market doesn't move as expected so you might want to diversify your portfolio to spread the risk. 

If you're feeling confident about what you've learned, you can head to our app and start trading in derivatives.