What is Contango (and why every investor should know it)

Investors are constantly confronted with new concepts, and in order to be successful in investing you need to understand all the factors that can affect your portfolio and its holdings. Those who invest primarily in stocks usually know the ins and outs of the companies they own stocks in and the risks they face. Invest in futures – or in exchange-traded funds that themselves have stakes in futures contracts – can put you at risk that you’ve never heard of before.

One of these potential risks is called a contango, and it involves the relationships between different futures contracts on the same commodity. Many ETFs have been plagued by the long-term negative impact of contango, but unless you know what it is, you won’t necessarily know if an ETF is using an investment strategy that puts you at risk. .

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What is contango?

The terms contango and offset both refer to current conditions in a futures market for a given commodity. A futures market is said to be in contango if the price of a futures contract that expires earlier is lower than the price of a futures contract that expires later. If the price of the last contract is lower than the one that expires the earliest, then the market is said to be offset.

To understand why contango is important, it’s important to know how futures trading generally works. For most commodities, there are a relatively small number of futures market participants who are genuinely interested in buying or selling the underlying commodity. For example, oil producers could sell crude oil futures to set the prices for their output, while petroleum refiners could buy futures to lock in what they will have to pay for crude oil. crude to make gasoline, diesel fuel and other refined products. Likewise, farms may eventually sell crops to manufacturers of processed foods who require these crops as ingredients for their prepared foods. In these cases, these parties will hold their futures contracts until they expire and then fulfill the delivery responsibilities under the contracts.

Most futures investors are speculators who don’t want to deal with thousands of barrels of oil or thousands of bushels of corn. For them, the natural thing to do is to close their futures positions just before the contracts expire. These speculators can either find other speculators on the other side of the trade with offsetting positions, or find investors like the ones above who are genuinely interested in holding the futures contract until it expires. After that, many speculators simply turn around and open a similar position in a futures contract at some point in the future.

This would not be a problem if the prices of the futures contracts in different months were the same. But most of the time the price is different. In particular, for a deferred market, the price of the replacement futures contract will be higher than the price of the contract which has just expired. This creates a small amount of friction which over time can cause the return of a given futures investment to drop dramatically compared to the spot price of the underlying commodity.

Where you will find the contango

Contango has had the greatest impact on ETFs investing in futures. Products like United States natural gas (NYSEMKT: UNG) and United States Oil (NYSEMKT: USO) have lost most of their value over the past decade, and only part of their drops stem from low energy prices. The dominant contango gradually eroded ETF assets by forcing funds to pay progressively more to renew futures contracts expiring month after month.

However, you cannot count on a given market that is always in contango. For example, crude oil futures have generally traded at higher prices than spot crude, but in recent months, strong demand has pushed up spot prices and caused the market to drift. .

Some products are subject to seasonal fluctuations which sometimes cause them to be postponed and other times to be postponed. For example, the demand for natural gas is highest in the winter due to the demand for heating, so the prices of futures tend to rise as you move into the late fall and winter months. winter. In the spring, prices fall with the return of warm weather, so the futures contracts reflect this drop in demand with prices lower than in previous winter months.

One area that has long been open was the volatility futures market. For years, those betting against rising volatility could invest in futures and make small but steady incremental gains. The risk was that a sudden rise in volatility would create losses that would wipe out all those little gains, and many investors discovered this the hard way earlier this year during a brief spike in volatility when reverse volatility ETF stocks like ProShares Short VIX ST Futures (NYSEMKT: SVXY) suffered catastrophic declines.

Know the risks

Futures contracts are very useful in some cases, but they come with risks that most equity investors are not familiar with. By being aware of carry-over and carry-over, you can identify potential long-term threats to your wallet that others will miss, avoiding unpleasant and costly mistakes.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.