Stack and Roll

Hedgers with large positions will often choose to reduce liquidity risk by "stacking and rolling" the hedge. A stack hedge is a position concentrated in one specific futures contract month as opposed to a string of contracts that extend out to the maturity of the swap, or obligation being hedged.

A hedger employing a stack and roll hedge will typically hedge the vast portion (or all) of their exposure in the nearby contract. As that nearby contract approaches maturity, the hedger must roll out of the hedge by closing out the nearby contract and reestablishing the hedge in the next month contract. As the position is rolled forward, hedgers will reduce their position by the reduction in the commitment.

In the simplest example, assume a producer wanted to hedge 100,000 barrels of oil over a 10-month period. Rather than selling 10 futures contracts in each of the months to be hedged, the producer could sell 100 contracts in the front month to establish the hedge. When that month was expiring, the producer would buy back 90 of the front month contracts (the hedge would be reduced by 10 contracts each month) and then sell them in the next month contract, until the conclusion of the period.

Because the term structure of energy prices is not stable, however, this strategy can be extremely risky. If the market is in backwardation, a short basis position (short cash, long futures) will always show a profit. Because nearby prices are higher than deferred prices, rolling the position forward means that the price at which futures are sold (nearby contract) is greater than the purchase price of the next month contract. However, if the market shifts into contango, the short basis position will incur losses. The opposite scenario holds for a long basis position. The possibility of a sudden change in the term structure from contango to backwardation, or vice versa, can put a stack and roll "hedge" at great risk.