Floor Trader Pearls: Burned by Oil Rolls

Print
https://tickertapecdn.tdameritrade.com/assets/images/pages/md/
2 min read

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.

undefined

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.

Call Us
800-454-9272

Commodity ETFs may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Commodity ETFs may be subject to greater volatility than traditional ETFs and may not be suitable for all investors. Unique risk factors of a commodity fund may include, but are not limited to the fund’s use of aggressive investment techniques such as derivatives, options, forward contracts, correlation or inverse correlation, market price variance risk and leverage. This information is for educational purposes only. This is not a recommendation to trade any specific security.

Futures trading is not suitable for all investors as the risk of loss in trading futures is substantial. Futures trading privileges are subject to TD Ameritrade review and approval. Not all account owners will qualify. Futures accounts are not protected by the Securities Investor Protection Corporation (SIPC). Equity options trading involves risks and are not suitable for all investors. Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. Futures and futures options trading is speculative, and is not suitable for all investors. Please read the Risk Disclosure for Futures and Options prior to trading futures products.

adChoicesAdChoices

Market volatility, volume, and system availability may delay account access and trade executions.

Past performance of a security or strategy does not guarantee future results or success.

Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.

Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.

The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.

TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2018 TD Ameritrade.

Scroll to Top