Choosing the Right ETF to Avoid Contango::InvestMacro


by Ino.com

– ETF investors who regularly buy and sell inverted products know what contango is. But it is possible that the average investor does not understand the ins and outs of what contango is and how it can harm an investment.

With a little knowledge, you can actually use contango to your advantage and profit from an investment that is already losing value.

What is contango?

In short, it is the cost of buying futures, options and derivatives. When you invest in a fund, usually but not always an ETF with leverage, for the fund to gain this 2X or 3X leverage, it must buy monthly futures and options contracts.

Then at the end of the month, the fund will sell their existing contracts with very close expiration dates and buy the following month’s contracts that have a longer expiration date. In the process of doing this, the fund will sell a contract at a lower price and then buy a contract at a higher price.

This happens because the higher the expiration date of the options contract, the higher the cost of the contract. This is because the buyer of the contract has time on his side and the seller takes on more risk because the value of the underlying asset has more time to make a big move.

Since the price of dated contracts is always more expensive than what the fund is selling their current contracts, the fund is constantly burning money. This money is burning, called contango. The money being “burned” literally reduces the amount of money the fund has to invest and over time causes the price of the ETF to slowly shrink. (For example, a $25 ETF would only be worth $20 over a few months, even if the underlying investments the fund tracks remain exactly the same over that entire time period.)

On a one-day basis, investors don’t usually see or feel contango, but over the course of a few weeks or even months, they will definitely feel it.

How to make Contango work for you

One way to take advantage of this burning money in contango is to ‘short’ it out for the various ETFs that suffer from this phenomenon. However, shorting a stock may not be in the cards for all investors because it is risky and capital intensive, especially when you are trying to sell an investment for an extended period of time.

Another slightly less risky method with significantly less capital outlay is to buy put options in ETFs that face high levels of deferment. Buying put options is a little less risky because outright shorting the stock can actually cost the investor more than a 100% loss.

With put options, your maximum pain is a 100% loss. If you short the stock and the stock goes up, you could lose more than 100% of your initial investment because the stock price has no ceiling. The options are still risky, but again a little less risky.

How is that? Let’s say you want the acronym Invesco QQQ Trust (QQQ), which is essentially the Nasdaq. But you don’t just want to short it, you really think it’s going down so you want a bit of leverage.

You can find the ProShares UltraPro Short QQQ ETF (SQQQ). This is an ETF that is 3X short of QQQ or Nasdaq. The price of SQQQ will rise when the NASDAQ index falls. However, SQQQ tests continuous control due to the way it produces 3 times leverage.

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Now the ProShares UltraPro QQQ ETF (TQQQ) is the opposite of SQQQ and gives investors three times the leverage in the upside of the Nasdaq or QQQs. If you have a strong conviction that the Nasdaq is trending higher, then TQQQ is for you. But again, contango will have an effect on your TQQQ returns if you hold it for more than one day.

Your choice not only to avoid contango, but to make it work for you is to buy put options contracts on TQQQ or SQQQ depending on which way you think the Nasdaq will go.

The way this works is by buying short contracts on the opposite ETF rather than the way it is designed to move. If you think the market is trending higher, you usually buy the TQQQ ETF. But if you want to avoid contango, you are actually buying SQQQ put options. This is because if the market goes up, SQQQ will lose its value and at the same time the contango will lower the price on a daily basis slightly.

Now, if you think the NASDAQ is trending lower, you can by placing options on TQQQ, since this ETF will go up if the market goes up and lower if the market goes down.

I’m just using TQQQ and SQQQ as examples, but you can do this with any ETF with leverage which will test contango. Also, you need to remember that contango will only affect the price of the ETF if you hold the ETF for longer than one day. And even if you keep it for only a few days, the effect will usually not be noticeable. This strategy will work best if you plan to hold put options for a few weeks or months.

Matt Tallman
Contributor to INO.com
Follow me on Twitter mthalman5513

Disclosure: This contributor was not holding a position in any of the above investments at the time of this blog post, but buys and sells put options in the TQQQ and SQQQ ETFs from time to time. This article is the opinion of the contributor himself. The above is a matter of opinion and is provided for general information purposes only and is not intended to be investment advice. This contributor does not receive compensation (other than INO.com) for their opinion.

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source: Choosing the Right ETF to Avoid Contango


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