CFAI Page 199 Reading 38 “Why would anybody use a stack hedge?” Two explanations given: 1 - Near term contract are more liquid and have more volume 2 - If YC flattens, you would have locked in a lower price. Aren’t those reasons for using a Strip Hedge? Typo from CFAI or I am not understanding?
Strips are a set of contracts with varying maturities. In their example they have a need for 100,000 barrels of oil each month for a year. They would lock in current prices for the strip by going long each delivery contract in next 12 months. Then when they need the oil in a month , the short will deliver the oil , but prices are hedged. But this can be costly if the later term contracts are not as liquid or if the price curve is steep. A stack is done when you only lock in the nearby ( first month) delivery contract for 12 times your monthly requirement. The idea is that the nearby has the greatest open interest , so it is relatively liquid , plus if the curve is looking steep then it is also the lowest priced. You take delivery as usual for 1/12 of the contracts and “roll” the rest. i.e. when time comes to expiry of the nearby for the unused contracts , you sell the front and go long to the next nearby ( i.e. the next month out ). Usually with backwardated markets such as oil market usually is, you can collect a roll yield because the front has a higher price relative to the back. This is the situation also when your bet on the curve flattening pays off . Essentially a month ago the next nearby was relatively higher priced , and it has dropped now so it is cheaper to roll into it. It is called stack hedge because unlike strip you load up at the bottom ( i.e. the first nearby ) and roll ( hence stack and roll ). If there is contango ,you could lose a bit , but probably not every time over a year, and certainly much ess than buying a whole strip of illiquid contracts
Time to Stack and Roll…Why? 1) Near term contract are more liquid. (<1month) 2) Forward Curve is steep now. (flatten next month)
deriv108 Wrote: ------------------------------------------------------- > Time to Stack and Roll…Why? > > 1) Near term contract are more liquid. (<1month) > 2) Forward Curve is steep now. (flatten next > month) I disagree with your second point. I rather perform a stack and roll when the forward curve is inverted (backwardation).
if forward curve were inverted … each time aren’t you losing on your contract if you bought them? since you bought them at say 110$ but price has now falled to 100$… (opportunity cost).
cpk123 Wrote: ------------------------------------------------------- > if forward curve were inverted … each time > aren’t you losing on your contract if you bought > them? since you bought them at say 110$ but price > has now falled to 100$… (opportunity cost). Well, I would agree except you’re letting them expire and rolling them over (at cheaper prices), not selling them. That’s why the roll yield is positive.
if in backwardation, strip hedge would be probably better (you lock-in the advantage of the backwardation - from long perspective), but the question is not only how the curve looks like now, but what you expect to happen. rolling would produce same result as strip hedge, if the backwardation (slope) does not change…
janakisri - this was a great explanation, helped me understand strip vs. stack hedge. my question is in the book I believe it said that Stack hedge would profit if there was Contango in the futures markets, not Backwardation. Can you please clarify? I see below there are comments on the (+) roll yield from backwardation as well. I guess I am just confused which is correct…
Thanks!
Not sure of this point , but bacwardation should help the stack hedge holder . You are continuously rolling into underappreciated contract and letting it rise . In the case of the strip hedge also you’re doing it , but the back months should be less volatile , so you’re not getting as much bang . With the stack you have potentially much larger percentage in the most volatile contract ( Samuelson effect )
appreciate the clarification, i think it’s possible that I may have wrote it down wrong or misundersood in some way.
thanks!