Index Roll: What It is, How it Works, Disadvantages

What Is an Index Roll?

The term index roll refers to a passive index investment strategy that uses a combination of index funds and long-term equity anticipation securities (LEAPS). An investor who uses this strategy must roll over a series of LEAP options to gain exposure to a long-term move in an index. Leverage from the options allows the investor to magnify gains and may result in outperforming an index over the long run.

How Index Rolls Work

Investors have a wide range of investment strategies at their disposal—both active and passive investment approaches. Active investing uses a hands-on approach by trying to outperform the market's average returns by taking advantage of short-term changes in price. Passive investing, on the other hand, uses a more long-term approach by taking a back seat.

Essentially, those who invest passively take a buy and hold approach and usually track an index to try to mimic its returns. Index rolling is one of the passive investment strategies that investors tend to use.

Index rolling is a long-term passive investment strategy that investors have at their disposal. People who take advantage of this approach may gain the same exposure they would if they invested in a standard benchmark, but often with less capital because of the exposure from the long-term equity anticipation securities (LEAP) option.

An investor may implement a roll forward using the same strike price for the new one as the old one, or they may be able to set a new strike. A new contract with a higher strike price than the original option contract is called a roll up, while a new contract with a lower strike price makes the strategy a roll down.

Over time, the position has very similar payoff characteristics to a regular indexing strategy. But returns tend to be slightly higher. That's because of the exposure from the option in the early stages of the setup. Volatility determines option prices, with lower volatility leading to lower costs for buying options.

Special Considerations

Many buy and hold investors prefer LEAPs. These are publicly-traded securities with expiration dates that extend beyond one year. LEAPs allow the buyer to purchase or sell the underlying asset before the expiry date at a predetermined price.

LEAP call options may be replaced with call options that have later expiration dates, essentially allowing the investor to roll their participation in the asset underlying the option forward indefinitely. LEAP call options can promote greater capital efficiency because they require less capital than buying the asset itself—in this case, an equity exchange-traded fund (ETF)—by employing a LEAP strategy called a roll forward option.

Disadvantages of an Index Roll

A roll forward involves extending a contract beyond its original expiration date. This is normally done shortly before a contract expires. Investors should consider the cost of rolling options forward before implementing this strategy, as rolling requires the investor to close out one option position, potentially at a loss while purchasing a new position.

An index roll strategy employs LEAP call options on a specific equity index ETF. However, LEAPS are not available for all ETFs. This narrows down the range of asset classes for the strategy. A list of LEAPS options can be found at the Chicago Board Options Exchange (CBOE).