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Contango and its use (2/2)

30 Nov 2017,

In the last part of our series we have explained the concepts of contango and backwardation, and we have said what does it mean when the market is in contango or backwardation.

 

Let me now show you how based on ETFs or ETNs, we can use the contango phenomenon in our benefit. The existence of contango or backwardation is very important for investors who wants to hold a medium or long-term exposition on such ETF. Contango works on these ETFs as a ravage of time that devaluates its price. On the other hand, backward adds additional revenue.

Are you asking why? Just look at the structure of these ETFs. The ETF typically holds an exposure on the first futures contract of the underlying asset to create an exposure on that asset. As time passes and the first futures contract approaches to its due date, ETF sells its exposure for the first futures contract and buys the exposure for the more distant second futures contract.

For example, in the case of a volatile ETN: the mechanism of VXX, even though its price is determined by the market, it is very closely related to the value of the index that follows the portfolio of two nearest futures contracts on the VIX index. So, in a situation where there is the contango on the market, ie the nearest contract is cheaper than the following contract, this instrument loses its value, because it simply does the exact opposite of what a good investor should do, it sells cheaply and buys expensively … simply said, in order to keep the exposure in the instrument, it gets rid of the cheap existing futures contract, while it has to to buy the following expensive futures contract.

Therefore, It is no wonder, that the chart of its development looks like this for the last year:

 

VXX 2017

Fig.1: VXX – last year’s development (source: TD Ameritrade)

 

Since its launch, VXX has recorded a massive loss of more than 99%, from its initial (recalculated from today’s perspective and totally extreme) level worth of more than 100,000 in 2009, falling to the current 31.20. All this is due to contango effect and its operational mechanism, which virtually excludes it from the long-term holding in an investment portfolio. Moreover, we can read in the manual that this product is intended for short-term possession and protection against sudden and unexpected drops in the market and its long-term possession is not recommended.

 

VXX vývoj od spuštění

Fig.2: VXX development from its beginning (2009) (source: TD Ameritrade)

 

Perhaps you may think that in such case the best way would be to go short – speculation on the decline will be the best way. This is, of course, true, but only partially. There are at least 2 reasons why direct short is not the right way to fully use the potential of this phenomenon, especially taking into the account potential risks.

 

  1. The significant fall in stock markets and associated rapid growth of VXX – despite the fact that this instrument is declining in the longer term, it is never possible to exclude a situation – maybe just a  short term one- when due to increased volatility the VXX will rise sharply (or similar volatile ETF / ETN) – often by hundreds of percent. Therefore, while clean short seems to be a very attractive option with significant profit potential, we recommend especially to beginners to avoid this path. In the case of the opposite trend and the absence of adequate hedging, the losses may be undesirable.
  2. When shorting volatile ETFs / ETNs, you will often pay so-called borrowing-fee, or borrowing costs for selling speculation, that means in simple terms following: – if you speculate on a decline, you will pay some amount for holding position overnight. The longer you trade, the more you pay.

 

From our point of view, the use of options – especially secured options such as vertical spreads – seems to be a beneficial and conservative way of profiting from the phenomenon of the long-term decreasing trend of such a structured market. We will talk about it in next part of our series.

In other parts, we will also introduce you other interesting candidates within the ETF / ETN, which are ideal for a long-term short.

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