My Questions to Alex: How long of a contract do you buy?

You mention in the book about trading out of an expiring contract, when? specifically, 10 days prior or more? If you are staying with the same trend, wouldn’t a long contract be more profitable?

Alex’s Response:

Hi John,

Normally I would always buy the front contract, the first one to expire. As a rule of thumb, I roll them over to the next contract about 2 weeks before expiry (which is about 10 business days). Financial contracts like the S&P 500 or Treasury bonds tend to remain liquid for longer so you can go closer to expiry (a week or so).

When we do catch a trend, the position might stay open for months, but this doesn’t necessarily mean that it’s better to be in a farther expiry. Depending on the situation with contango and/or backwardation, you could have a significant “roll yield.” For example, suppose you’re in an up-trend and you have a long position. Often, up-trends will coincide with backwardation: farther expiring contracts will be priced lower than the current and when you roll from the expiring contract to the next, you’ll often sell at a higher price and buy at a lower price. So long as the trend continues, this will result in a positive roll yield. On the other hand, if we have contango (farther expiries are more expensive), you’ll have a negative roll yield and you might consider taking a position in a farther away contract. Unfortunately, there isn’t an exact science to this.

Another important issue is sizing your trades. As I may have mentioned, I always advocate equal risk weighting as a way to size positions, and this is a bit of a mystery even for the people who are in the investing business. Many determine allocations as a % of their portfolio in nominal terms, but this distorts risk exposure for the simple reason that different markets fluctuate differently. Some, like Silver or Crude Oil, can be very volatile. Others, like FX pairs or shorter-dated Treasuries, far less so. As a consequence, your Silver position could turn out far riskier than your 10-year Note position. The way to measure their relative riskiness is to calculate their respective value-at-risk: by how much the value of your exposure changes, given the price fluctuations. It is not a complicated calculation if you can get the time series (price history), perhaps the last 12-18 months of it.

I’ve attached a simple worksheet with a few explanations that should help you make this calculation for each market you follow. To get an “equal risk weighting” you’d size your position so that the value-at-risk in each is as similar as possible for all markets you trade.

If anything about the above remains unclear, or if other questions arise, please let me know.

Best, A.