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Recently, I wrote an article discussing my techniques for trading diagonal spreads, which was a general overview, including preferred strike prices, dates, and pros and cons. If you haven't read it, feel free to read it here.

I'd like to continue the series on Diagonals by discussing something a bit more specific, trading contango. To do so, I'd like to take a bit to summarize contango, and then I will discuss two possible trades, and finish with a recent real world example.

CONTANGO

Simply put, contango is a condition within the futures market where contracts that expire in the future have higher prices than the spot price. So, if a trader looks at a 12 month natural gas contract, he/she can expect prices to be higher than current spot prices. For futures on assets that are not perishable, this is a common phenomenon. Higher prices for contracts further out reflect real world costs for the agent holding the physical asset, such as storage costs. (Readers are welcome to supply further amplification, as I am not a futures trader, but I would love to get in the weeds on this subject).

For those of us trading in equities and ETFs, contango comes into play when we venture into the world of futures based ETFs such as USO, GAZ, UBG, GSG, and UNG. Even ETFs based on intangibles, such as the VXX, which is supposed to mirror the VIX, can be subject to contango risks.

A quick through commodity based ETFs will demonstrate that not all of them suffer equally from contango. Long term charts of DGL and GLD, for instance, look pretty rosy. Long term charts of UNG, GAZ, and VXX, however, are pretty ugly. (Charts are courtesy of Yahoo finance).

(click to enlarge)

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The differences lie in how the ETF is structured, and whether the underlying asset has been strong enough to overcome the effects of contango. DGL and GLD, both track gold. As readers may have noticed, gold has done quite well over the past decade. But more importantly, DGL and GLD have inherent protections that help to protect them from contango to some degree. First, GLD is based on physical holdings of gold. Therefore, holding costs are passed onto the investor through the ETF management fee, but are not subject to contango loss due to futures rollover. DGL uses future contracts to track gold, but when underlying contracts expire, the fund manager is free to choose a new contract that provides "maximum roll yield". Roll yield usually refers to backwardation, where a futures trader is attempting to profit by taking large premiums on contracts by selling and rolling to contracts further out that are cheaper. Here, DGL means that they will select the contract that mitigates costs to the greatest extent possible.

UNG and VXX are different. Both are structured to repurchase contracts that are a month out, as soon as current contracts expire. Because of the inflexibility built into the product, the fund manager has no control over contango loss, and long term holders are bound to pay over time.

TRADE IDEA

In my opinion, anyone long on the VXX or UNG (or any other futures backed ETF structured similarly), is paddling upstream needlessly. If one wants to bet that the market will fall, there are a number of options strategies that can be employed against the SPY (such as, a put diagonal spread). If one wants to bet on a boom in natural gas, one can find numerous companies that specialize in natural gas production, or transportation. If none fit the bill, a trader can at least stick to UNL, which has some protection against contango.

However, the clever trader CAN take advantage of the rip-tide VXX and UNG fight against. Instead of betting on their rise, bet on their fall. By purchasing a Deep in the money put (at least a year out preferably), and selling out of the money puts (the closer to now the better!), a relatively safe bet can be built that essentially capitalizes on the slow (sometimes rapid) bleeding the position experiences.

For the aggressive and diversified trader, this bet can be made against both positions at anytime. If VXX and UNG have been beaten down, the premium on the long put will be fairly high, but premiums on the short should be high as well. Of course, there is always a danger of a rebound. Currently, many people feel that the S&P is due for a drop, and the VXX is likely to spike with it. Numerous SA articles discuss the imminent rise of natural gas prices, which, if rapid enough will push UNG much higher. While one of the advantages of a diagonal spread is that it can overcome short term spikes, or even long term miscalculations in direction (if they are not extreme), it is probably prudent to enter this trade when one also feels direction is on his/her side.

Therefore, the optimal time to enter this VXX trade would be anytime the market has undergone a prolonged dip. The market may continue to dip, but the VXX is unlikely to keep up with the fall percentage wise as the months pass by. The optimal time to enter the UNG trade would be after a sharp spike upwards in natural gas. The same principle applies. It will be difficult to call a top to a price rise, but the trade is really a bet against the UNG structure, not natural gas.

UNG Trade

Last month I closed a test trade on UNG based on these principles. Immediately after I purchased the ETF, the price began to climb. After chasing the price up by buying back the $16 Apr puts and selling the $17 Apr puts, the ETF proceeded to crash. As stated in previous articles, this trade tends to limit returns under rapid price movements. Therefore, if you are absolutely confident that you have the timing and magnitude of the drop correct, buying puts or selling short will most likely yield superior results. I am generally wrong in regards to timing in the short run, and I prefer to sacrifice some profit potential for downside protection.

UNG trade activity

date

trade

proceeds/costs

underlying stock price

3/13/2012

Bought 2 UNG Jan 19 2013 22.0 Put @ 5.92

-$1,190.53

$17.74

3/13/2012

Sold 2 UNG Apr 21 2012 16.0 Put @ 0.5

$98.46

3/16/2012

Sold 2 UNG Apr 21 2012 17.0 Put @ 0.48

$89.46

$18.40

3/16/2012

Bought 2 UNG Apr 21 2012 16.0 Put @ 0.27

-$55.53

3/20/2012

$18.28

3/27/2012

$17.19

4/3/2012

$16.35

4/10/2012

$15.24

4/16/2012

Sold 2 UNG Jan 19 2013 22.0 Put @ 7.61

$1,515.43

$15.14

4/16/2012

Bought 2 UNG Apr 21 2012 17.0 Put @ 1.81

-$363.53

Profit =

$93.76

or 7.88%

As you can see, the result was 7.88% in just over a month, or about 80.15% annualized. With the recent rise by UNG, closing the position seems rather prescient. I assure you that I had no idea whether UNG was headed up or down. The decision was based simply on the fact that I held short 2 Apr 21 puts with `$17.00 strike prices while the underlying position was in the low $15's. I had three choices at this point. First, I could close the shorts and leave the long put open to prosper on any additional drop in the ETF price. Second, I could roll the shorts forward and down, and third I could close the position entirely.

I don't typically hold long options by themselves, eliminating option one. I don't mind rolling forward when the situation warrants, but in this case I had chosen to buy puts with an expiration date of Jan 2013. Had I rolled forward, I would have eliminated a good deal of time on the trade before the long expired. The rates of time decay on the shorts would have been similar to that of the long positions, and I would have lost much of the benefit in that aspect. Additionally, price swings on the long position become increasingly volatile as the expiration date approaches, and I wanted to avoid the associated risk. Therefore, I closed the position.

Closing remarks

This article mentions several hot button assets (such as the mention of precious metal ETFs, and natural gas ETFs), so if I'm lucky enough to receive responses, I expect some of them to be emotional.

I'd also like to point out that I currently have diagonal put spreads in action against both VXX and UNG. I did not open these positions within the last 72 hours, and do not intend to alter them within the next 72 hours.

Source: Diagonal Spreads: Prosper From Contango, Don't Suffer From It

Additional disclosure: I am short UNG via option positions, and have both long and short option positions on VXX. I receive no compensation to write about any specific stock, sector or theme.