Schweser Definition:
“Strip hedges and stack hedges are prevalent in industries where producers sign
agreements to deliver amounts of oil or other commodities in a sequential fashion. For
example, an oil producer might have signed an agreement to deliver a fixed amount
of oil each month for the next year. One method of hedging the price risk is to
immediately go long in a series of forward contracts (i.e., a strip hedge) with delivery
dates and amounts matching the agreement. In this fashion, the producer effectively
locks in the monthly forward curve for the next year. Bid-ask spreads tend to widen
as the contract maturity increases, however, because longer-term contracts can be very
thinly traded (or even non-existent). This can make the strip hedge costly or even
impossible to implement.
To help reduce transaction costs, the oil producer might instead utilize a stack hedge.
To form a stack hedge, the oil producer would enter into a 1-month futures contract
equaling the total value of the year’s promised deliveries. As transactions costs are less for
short-term (e.g., 1-month) contracts, the total cost of implementing this strategy is less
than for a comparable strip hedge. At the end of the first month, the producer rolls into
the next 1-month contract, and so forth, each month setting the total amount of the
contract equal to the remaining promised deliveries. This strategy of continually rolling
into the next near-term contract is referred to as stack and roll.”
I always thought rolling short term futures has higher transaction cost, don’t they?
“Strip hedges and stack hedges are prevalent in industries where producers sign
agreements to deliver amounts of oil or other commodities in a sequential fashion. For
example, an oil producer might have signed an agreement to deliver a fixed amount
of oil each month for the next year. One method of hedging the price risk is to
immediately go long in a series of forward contracts (i.e., a strip hedge) with delivery
dates and amounts matching the agreement. In this fashion, the producer effectively
locks in the monthly forward curve for the next year. Bid-ask spreads tend to widen
as the contract maturity increases, however, because longer-term contracts can be very
thinly traded (or even non-existent). This can make the strip hedge costly or even
impossible to implement.
To help reduce transaction costs, the oil producer might instead utilize a stack hedge.
To form a stack hedge, the oil producer would enter into a 1-month futures contract
equaling the total value of the year’s promised deliveries. As transactions costs are less for
short-term (e.g., 1-month) contracts, the total cost of implementing this strategy is less
than for a comparable strip hedge. At the end of the first month, the producer rolls into
the next 1-month contract, and so forth, each month setting the total amount of the
contract equal to the remaining promised deliveries. This strategy of continually rolling
into the next near-term contract is referred to as stack and roll.”
I always thought rolling short term futures has higher transaction cost, don’t they?