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Strips are a set of contracts with varying maturities. In their example they have a need for 100,000 barrels of oil each month for a year. They would lock in current prices for the strip by going long each delivery contract in next 12 months. Then when they need the oil in a month , the short will deliver the oil , but prices are hedged.

But this can be costly if the later term contracts are not as liquid or if the price curve is steep.

A stack is done when you only lock in the nearby ( first month) delivery contract for 12 times your monthly requirement. The idea is that the nearby has the greatest open interest , so it is relatively liquid , plus if the curve is looking steep then it is also the lowest priced.

You take delivery as usual for 1/12 of the contracts and "roll" the rest.

i.e. when time comes to expiry of the nearby for the unused contracts , you sell the front and go long to the next nearby ( i.e. the next month out ). Usually with backwardated markets such as oil market usually is, you can collect a roll yield because the front has a higher price relative to the back. This is the situation also when your bet on the curve flattening pays off . Essentially a month ago the next nearby was relatively higher priced , and it has dropped now so it is cheaper to roll into it.

It is called stack hedge because unlike strip you load up at the bottom ( i.e. the first nearby ) and roll ( hence stack and roll ).

If there is contango ,you could lose a bit , but probably not every time over a year, and certainly much ess than buying a whole strip of illiquid contracts



Edited 1 time(s). Last edit at Saturday, March 26, 2011 at 11:22PM by janakisri.