Contango - It's Not Dancing With the Stars
Contango ñ It's Not Dancing With the Stars
Commodity Futures trading is an exciting arena for some traders and an absolute nightmare for others. For many of us, the leverage and volatility that come with the Commodity markets make sense. We understand that to survive in this asset class, we must have goals, a trading plan, discipline, risk management, a strategy with an edge and sufficient funds in our trading account.
Other traders who try and learn Commodity trading on their own, or just treat it like a hobby, are finding it to be more challenging than originally thought. Trading accounts are opened every day with dreams of becoming rich overnight and never working again, only to watch their hard-earned money evaporate. If they only knew that Futures trading is "the hardest easy money they will ever make." Unfortunately, these people become part of that 90% failure rate we often hear about. No trading plans, no trading education, lack of capital and the list goes on and on.
During our Commodity Futures classes at Online Trading Academy, we help our students understand the Commodity markets and teach them what is needed to succeed. We also offer alternative vehicles for trading Commodities because we understand that Commodity Futures are not for everybody. One of the other vehicles is an Exchange Traded Fund (ETF). I like to show students how they can participate in Commodities without the risk of leverage if they so choose.
Commodities are a supply and demand driven market affected by seasonality and speculation. We are seeing more demand for raw Commodities today than at any time in our history. The reason ñ the world population is growing. Just this week, the 7 billionth baby was born with plenty more to follow I am sure.
By understanding how Commodities impact us and our economies, an astute trader/investor may be able to capitalize. By using Commodity ETFs, you can diversify your portfolio to protect against inflation and participate in capital appreciation at the same time. When a trader/investor purchases these ETFs, they are looking for a derivative that will follow very closely the underlying Commodity that the ETF tracks. This allows them to participate in some very amazing moves in the Commodity markets without the risk of losing more than they invested. For some, this is a very comforting feeling and they are able to focus more on the trade than the risk of loss.
One of the drawbacks to these ETFs is that sometimes they do not perform as well as the underlying Commodity due to Contango. Commodity Futures markets are always either in Contango or Backwardation. What these two states of market prices are telling investors is how much supply and demand there is for that particular Commodity, now or in the very near future.
- Contango ñ Market prices are getting more expensive for each back month of the Commodity
- Backwardation ñ Market prices are getting less expensive for each back month of the Commodity
Notice how that with each month, starting with December and going to March, the prices are getting less expensive; this is called Backwardation. Normally, Commodities are stored for future delivery. With this storage comes cost that must be built into each month the Commodity is stored. This would reflect higher prices in the back months compared to the front month. When you see Backwardation in the price structure, there is a huge demand for that Commodity right now and there is no storing of the Commodity.
The Corn prices show the front month December being the lowest price and with each back month the prices are getting more expensive. This is called Contango which reflects a carrying charge for storing Corn until future delivery, a normal pricing structure for a Commodity. Contango tells you the supply and demand is normal with sufficient amounts of the Commodity around to meet demand.
Now that we understand Contango and Backwardation, let's discuss some of the Energy ETFs since the world needs this sector on a daily basis. One of the biggest complaints from Energy ETF trader/investors is that the ETF underperforms. The main reason for this is Contango price structures in the Commodity that the ETF is tracking.
When a trader/investor purchases shares of an ETF from an institution (issuer) such as Barclays, Goldman Sachs, etc, the issuer is basically short that Commodity because you bought it from them. This leaves the issuer exposed to risk if price rises. To protect themselves, these issuers go to the Futures markets and purchase a long Futures contract to hedge their position.
Since all Futures contracts expire at some point, each contract has to be rolled over and a new contract purchased to keep the hedge position. The Energy market is in such high demand that the contract expires once a month. Now the problems begin for ETFs that have to roll these Futures positions over to the next contract month
If you purchase the United States Oil (USO) ETF and read the prospectus, you will see that they rollover the Futures contract every month. Table 2 shows us a market that is in Contango, and each month, price gets more expensive. The ETF keeps buying at the high and selling at the low each month when this condition exists. This affects the performance of the USO ETF and does not allow for good returns.
Another Energy sector ETF that tracks the Crude Oil market is United States 12 Month Oil (USL). The difference between USL and USO is that the issuer invests in the first 12 months of the Crude Oil market instead of just the front month. Doing this during Contango can save the issuer a lot of money and allow the ETF to track closer to the actual Commodity.
If a trader/investor sees the Energy Futures in a Backwardation scenario, then buying the USO would make more sense because then, with each contract rollover, the issuer would be buying lower prices and selling at higher prices. At this point, the USO will track much closer than its rival, the USL.
Being aware of Commodity price structure can help traders/investors even if they are not trading the actual Futures contracts. By reducing their risk and riding this hot Commodity wave with an ETF, most anybody can participate in this sector of investing.
"Strength does not lie in what you have. It lies in what you can give."
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