TRADESIGNAL HOW TO 11.
ADJUSTED FUTURES CONTRACTS.
Adjusting rollover gaps to avoid wrong decisions.
An essential feature of the futures market is the need to roll an expiring contract into the next. With technical analysis – in particular in the presentation of indicators andback tests – the correct handling of price gaps plays an important role. We will clarify this issue and show you how to create a continuous and adjusted contract.
TABLE OF CONTENTS.
- Rollover generate gaps in the chart.
- Wrong decisions due to distorted chart situation.
- The solution: Adjusted perpetual futures.
- Create adjusted perpetual contracts in 5 steps.
- Proper rollovers with Tradesignal.
- Advantages and disadvantages of various data adjustment methods.
NOTE: All examples use Refinitiv Eikon data and tickers.
ROLLOVERS GENERATE GAPS IN THE CHART.
THE MORE DYNAMIC THE FORWARD CURVE, THE BIGGER THE GAP.
Whether DAX, Bund, Oil or Gas – each futures contract has a standardized and fixed expiration date, analyzing and trading the underlying charts results in the problem that the price history ends on expiry. To make a long-term chart, so the old contract must be linked to the new one. Simply rolling the contracts, however, creates price gaps. These can be particularly high in the commodity markets due to the dynamic futures curve, as Figure 1 demonstrates.
FIGURE 01: PRICE GAPS DUE TO CONTRACT ROLLOVER.
WRONG DECISIONS DUE TO DISTORTED CHART SITUATION.
WHY A SIMPLE SEQUENCE OF THE CONTRACTS IS NOT ENOUGH.
The correct adjustment of the gaps is crucial, and we show you now, why. The simple concatenation/stitching of individual contracts ensures a distortion of underlying price information. This applies in particular in markets with a rising (contango) or falling futures curve (backwardation). Technical analysis based on this chart representation inevitably leads to wrong decisions. The following figure shows the unadjusted chart of the futures contract including rollover gaps in the upper half. Shown below is the backward adjusted chart, which was adjusted for gaps and thus represents the true price character.
FIGURE 02: UNADJUSTED VS. BACKWARD ADJUSTED CONTRACT .
The figure shows the unadjusted chart of the futures contract, including rollover gaps (upper half). Shown below is the backward adjusted chart. While above a breakout on the long side as well as a subsequent uptrend is suggested, in reality a downtrend channel (lower chart) persists.. A close look at the history of both charts reveals how different the respective conclusion for traders or analysts may be:
- A close look at the history of both charts reveals how different the respective conclusion for traders or analysts may be:
- Also, the subsequent trend direction is opposite: The upper unadjusted chart suggests an uptrend channel, while the adjusted contract in truth indicates a downtrend channel due to the last two up gaps.
This problem is also evident in the calculation of back tests. Rollover gaps, which are not tradable and therefore have no significance for the profitability of a trading position, ultimately influence and distort the results.
THE SOLUTION: ADJUSTED PERPETUAL FUTURES.
THIS IS HOW THE BACKWARD ADJUSTMENT WORKS.
The solution to this problem: adjusted perpetual contracts. They eliminate any rollover gaps caused by the contract change and thus display the actual price development. In the backward adjustment method, which is most commonly used, prices of prior contracts are corrected after a rollover occured.
EXAMPLE: If the June contract stands at 100 points at the time of the rollover event and the September contract at 96, so the rollover gap is minus 4 points. To remedy this in the adjusted perpetual contract, all the historical prices are corrected by 4 units down. The following diagram shows the adjustment process schematically. On the left a gap of 4 points can be seen, which occurs while rolling from one contract into the next. On the right side the adjusted contract is visualised in red. It was generated by adjusting the historical prices by 4 points down. The „artificial“ (non-tradable) gap was eliminated. Every time when a contract expires and is rolled into a new, all contracts will be adjusted. Warning: These adjusted prices do not correspond to actual traded prices in the past. Only the prices of the current contract represent real prices (trading reality). If one were to concatenate all contracts without adjustment to a perpetual contract, the historical prices would be correct (historical price reality), but the statement of the chart would be distorted due to the many rollover gaps.
FIGURE 03: OPERATION OF BACKWARD ADJUSTMENT METHOD.
In this adjustment method, rollover gaps (left chart) are eliminated by the retroactive adjustment of historical prices. The right graph shows the original contract in black, the adjusted contract in red.
CREATE ADJUSTED PERPETUAL CONTRACTS IN 5 STEPS.
BACKWARD ADJUSTMENT IN PRACTICE.
Tradesignal offers a wizard both a convenient and flexible solution for creating adjusted perpetual contracts. You will see below, step by step, how easy it is with Tradesignal to create them. The backward adjustment method (next page) presented before serves as an example here.
STEP 1: Click on the field “symbol list” and select “new symbol”.
STEP 2: Then click on “user-defined continuation“.
STEP 3: In the first column type in the corresponding icon of your data provider for the desired future; e.g. CL for the Thomson Reuters RIC for Crude Oil Light. Then mark all individual contracts you want to use.
STEP 4: Now select the desired rollover method. There are two methods for determining the rollover date:
- a. The rollover is done at a specific time, e.g. X days before the expiration date of the contract.
- b. The rollover is done based on the volume or open interest, e.g. when the volume of the next contract exceeds the current contract.
In the following example the old contract is rolled one day before the expiration date in the new contract.
STEP 5: Select the “Backward Adjustment” method, and then click “Next” and “Finish”.
STEP 6: Click “Done” and enter a name for the adjusted contract.
The created adjusted contract then stands in the securities folder defined by you and can be used immediately for back tests.
PROPER ROLLOVERS WITH TRADESIGNAL.
MODIFICATION OF ADJUSTED CONTINOUS CONTRACTS.
Adjusted contracts can be created quickly and safely with Tradesignal. This ensures a correct analysis of your charts and back tests. Indicators are also displayed correctly (no Gaps in RSI, MACD or Moving Averages).
BY THE WAY: The precise definition of an adjusted contract can be always checked and adjusted if necessary. For this purpose just click on the ticker symbol with the right mouse button and select “edit future definiton”.
FIGURE 04: EDITING THE FUTURE DEFINITION.
ADVANTAGES AND DISADVANTAGES OF VARIOUS DATA ADJUSTMENT METHODS.
CHOOSING THE ROLLOVER METHOD DEPENDS ON YOUR TRADING STYLE.
Each rollover method has its advantages and disadvantages. Using the backward method for long term charts could lead to negative prices. This feature does not occur in the proportional adjustment method. Here, the adjustment is carried out as a percentage, so that a constant ratio between all prices of historical time series is assured. The downside: The time series are only suitable for analysis on a percentage basis.
FIGURE 05: ADVANTAGES AND DISADVANTAGES OF VARIOUS ROLLOVER METHOD.
After weighing the pros and cons, the question arises, which method is the best option. A scientific study (see reading list below) provides a good guideline in answering the question: According to this research study, the choice of rollover method depends the trading style …
- For back tests in intraday trading, the use of unadjusted contract is recommended generally
- When trading strategies based on very long-term periods are to be back testetd, eliminating any rollover gaps is imperative. Here it is advisable to use the proportional adjustment method.
- For making trading decisions, the presented backward adjustment method is preferable.
READING LIST: S. Masteika, A. V. Rutkauskas, J. A. Alexander „Continuous Futures Data Series for Back Testing and Technical Analysis“
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That’s it for today. Take care, take profit and auf Wiedersehen.