A Simple Explanation of Contango

Some of the ETFs and ETNs I follow tend to decline over time, and the explanation is something called contango.  It’s very impactful in $UVXY,  but exists in any product that uses futures.

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You can look up the definition of contango in a lot of places.  Investopedia defines it as "When a market is "in contango" when the delivery price of a particular futures contract has to converge downward to meet the futures price." and that’s a good explanation, but if you don’t trade futures, it may still be hard to understand how it impacts these ETFs so severely. 

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For an analogy, imagine that you are given $100,000 in a bank account.  As part of that gift you are required to buy a new car every month, and to trade in the previous one.  It’s pretty common knowledge that a new car will lose a $1,000 in value when you drive it off the lot.  It doesn’t matter if you use the car or not.

We will use that knowledge to see what happens to your bank account over time. Every time each month when you trade in the car, you receive $1,000 less than its cost.  Therefore, each month the value of the car goes down by $1,000.  If the price of the new car is different than the last one, the bank account balance may go up or down, but eventually, the loss of value will catch up to your bank account. 

If you buy a car for $20,000, your balance goes down to $80,000.  Next month, you’ll trade that one in for $19,000.  If you buy a car for $15,000, you’ll see a bump to $84,000, but that’s only temporary.  The following month you’ll only get $14,000 for the trade and if you buy a car at the original price of $20,000, your account will drop to $78,000.

This is how contango works.  There is always an ultimate decline in value because of the rolling of the futures to another month.  Sometimes it may be delayed, but it is going to happen. 

The opposite of contango is backwardation (I wonder if someone made this name up) and it can occur, but not very often or for very long.  This is why I sell these products short.   On a long term basis, time is on my side. 

A rough day in the market, as the dropping Dow caused my short positions to lose me money.  It’s only one day. 

NUGT	9.03	10.47	1.44	13.8%
BIS	27.61	29.75	2.14	7.2%
TZA	9.05	9.90	0.85	8.6%
VIXM	52.48	54.17	1.69	3.1%
RUSS	33.12	30.40	(2.72)	-8.9%
CORN	23.36	22.68	(0.68)	-3.0%
FAZ	10.90	11.26	0.36	3.2%
UVXY	33.00	40.68	7.68	18.9%
FXP	28.14	27.58	(0.56)	-2.0%
XIV	48.78	48.70	(0.08)	-0.2%
SCO	55.57	55.93	0.36	0.6%