What is a Carry Trade?

One of the biggest differences between equities and commodities is that commodity futures usually have an expiry (settlement) date.

If you buy shares in a company, there is no timeline to do anything with those shares. You can hold them for days, months, years, or even decades.

But in commodity futures, each contract will be executed with a specific settlement date. As those dates approach, traders often need to move their futures positions to a date further in the future. This process is known as carrying, rolling, or executing a carry trade.

There are two types of carry trade: a borrow and a lend. Borrows = buying nearby and selling further out. Lends = selling nearby and buying further out. Importantly both legs of a carry trade are executed simultaneously so as not to create outright price risk.

They are usually quoted as the price between the two settlement dates rather than the outright prices, $10 contango or $7 back for example. This price difference is known as the spread.

There are several reasons a trader may execute a carry trade:

1) Physical deliveries often change. Let’s say a trader buys a cargo in September and expects to sell it in October. They hedge their purchase by selling futures to October, expecting to buy them back when they fix their sale price.

However, their sale gets pushed from October to November. They now need to adjust their short futures position before it expires and either settles physically or financially before their November sale.

They are short futures in Oct so they borrow - buy Oct and sell Nov - to square their Oct position and reestablish their futures short in Nov.

2) QPs may change. Physical contracts are priced against specific periods known as quotation periods (QPs). Let’s say a purchase and sale are supposed to price on the same day in August but the qp for the sale changes to M-1. This means the trader will now be hedging (buying futures) in July.

To avoid their long July futures position and short August futures position expiring open, they will need to lend - sell July and buy August - at which point they will be square both months.

3) A speculative trader wants more time. Not every carry trade is linked to a physical position.

Let’s say a trader is bullish and buys September futures. As September approaches they still believe the price will rise but they need to move their position - avoiding taking physical delivery or closing out the trade financially depending on the commodity.

Rather than closing their position they lend September - December. Their market view remains the same but the exposure has been moved further into the future.

4) Speculative carry trades. Traders often speculate on forward curves changing - moving from contango to backwardation or vice versa. By borrowing in a contango then lending that same spread they can generate profits (or losses if they get it wrong!)

Understanding carry trades is crucial for hedging and speculating.