Switch: What it Means, Example, Risks in Commodity Trading

What Is a Switch?

A switch, also known as "rolling forward," is a futures trading strategy involving closing a near month contract and opening a later month contract with the proceeds. Switching is not the same as spread trading. In a switch, the trader only owns one position at a time. In a spread, the trader is simultaneously both long one contract and short a different but related contract.

How a Switch Works

Traders use a switch when they wish to maintain their current positions and exposure in contracts that are nearing expiration. The investor could remain bullish or bearish on that particular market beyond the expiration date of their holdings. Or, they may wish to extend settlement to avoid costs of delivery, fees, and other expenses.

Example of a Switch

For example, let's say that it is currently January 2022, and an energy company that will have 500,000 barrels of oil to sell in June 2024 wants to hedge its position. However, the company does not purchase the July 2024 oil futures contract because they deem this contract too illiquid and thinly traded. The ideal contract has a delivery period of no more than 13 months in advance.

Therefore, a possible hedging strategy for the company is to sell short the appropriate number of July 2023 contracts. Then, in June 2023, it could close out the July 2023 position and switch to the July 2024 contract.

Other Forms of Switches

Options traders also use switches, because as with futures, these options have expiration dates. Switching is not possible in the equities market because stocks do not expire. For both a futures and an options switch, it is the same as a "roll over" or "roll forward." Basically, the trader extends the expiration date for their exposure to the market.

For options, the trader may change the strike price for the new position. Closing the current options position and opening a new trade at a higher strike price, and possibly with a later expiration date. The use of a higher strike and later date is called "rolling up." Closing the current options position and opening a new position at a lower strike price, and possibly with a later expiration date, is called "rolling down."

Risks of Switches

The biggest risk a switcher takes is the possibility of expanding or contracting spreads between the contract month sold and the contract month bought. For example, if the spread between the current month contract and the following contract widens near switching time, it could cost significantly more to buy the later month than the proceeds received from the near month. Rolling a short position into longer expiration would benefit from such a widening of the spread.

Spreads can widen for many reasons, from simple seasonal supply and demand to exogenous factors, such as a temporary shortage of the underlying commodity due to a production facility closure or war.