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Floor Trader Pearls: Burned by Oil Rolls

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August 1, 2014

If you’re trading futures-based ETFs, beware of the “rolling risk.” These days, trading terms may not be as complicated as “supercalifragilisticexpialidocious.” But close. Like flying nannies, market words are weird and wonderful. Understanding references like “contango” and “backwardation” could hold the secret to your success when you try to make sense of price moves in ETF products whose values are tied to futures contracts.

Remember a futures contract is an agreement to buy or sell something—like oil, for instance—at some time in the, well, future. In general, futures prices differ from “spot prices,” which represent real-time cash prices.

If a future price trades higher than the spot, this is called “contango.” If a future price trades lower than the spot, this is called “backwardation.” Note the table below.

As an example, crude oil is said to be “in contango” when longer-dated contracts trade at increasingly higher premiums over cash. This premium exists to cover the costs, for instance, of paying the storage for the oil between now and a futures expiration. As the contract gets closer to expiration, this premium begins to “decay,” until the price of the expiring future matches the cash.

For instance, assume a cash price of 100 per barrel, and 105 for a 30-day futures contract. If oil’s cash price remains unchanged, then 30 days later the expiring futures contract will also be worth 100. If you had bought the futures contract, you just lost 5.

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Just a Spoonful of Sugar…

What does this have to do with your trading life? Even though you’re trading an ETF, in reality you’re trading futures contracts (at least through the fund manager) because products such as oil ETFs—derive their prices from futures. The goal of an oil ETF isn’t simply to track the price of oil. It’s to track the price of oil using near-month oil futures.

As a fund’s near-term futures contracts approach expiration, those contracts need to be rolled over into longer-term futures expirations so the fund avoids being forced into taking physical delivery of all that crude.

And when the market is in contango, guess what? You end up paying more for the longer-term contract than what you receive from selling the shorter-term contract, and the net price of your investment goes down. This is called “roll decay,” and with oil futures expiring every month, this decay can really add up.

Remember that just because a market is in contango, and longer-term futures cost more than shorter-term contracts, that doesn’t necessarily ground your investment. It’s just a headwind to keep track of. Given that the value of oil, volatility, or whatever it is you’re trading, could go up, this change in the cash price might be enough to offset "roll decay." Or it might not. You may not have to clean chimneys, but watch the words that make the market. And above all, always work to understand the products you’re trading.

Carefully consider the investment objectives, risks, charges, and expenses of an exchange traded fund before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.

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