Email of the day on managing contango costs
Comment of the Day

June 06 2018

Commentary by Eoin Treacy

Email of the day on managing contango costs

Based on your very correct predictions, I am enjoying the run on the Nasdaq by owning futures on the Nasdaq 100.   It is time to roll and I notice there is a contango of about 23 on these contracts, giving an annual contango cost of 1.3%.  Small but annoying.

A very basic question to which I have never been able to find an answer - is there any way to optimize this, for instance by timing the rollover?  I can't find a chart of contangos anywhere.

Eoin Treacy's view

Thank you for this question which may be of interest to other subscribers and congratulations on your trading success. Generally speaking the contango reflects the interest rate. Since there is no prospect of a shortage of supply for synthetic contracts like index or interest rates futures I never looked at the contango chart before today. In fact, at only 1.3% one might think that the contango at present is a relative bargain considering the Fed Funds Rate is 1.75%.

This chart of the spread between the 1st and 2nd month continuation charts raises some important questions.  Period up to 2008 is as one might expect. We see spiky action around contract rolls as selling in one contract and buying in the next creates very short-term variations. However, the period during quantitative easing was universally in backwardation probably because of the deflationary influence of bond buying on interest rates.

The widening contango is certainly in tune with the Fed’s interest rate policy over the last couple of years but the big question is what has caused the spread to contract so meaningfully over the last couple of months? One possible answer is that upward pressure on the FRA/OIS spread and its effect on short-term funding costs may have had an influence on the relative pricing of index futures. That’s merely a guess but I can’t think of any other reason so perhaps subscribers may be have a better understanding?

As for how one manages the contango cost; within a range the baby steps trading strategy can be employed to sell the near-dated and buy far dated contracts. Alternatively, you can simply choose to own longer-dated contracts. If you time your purchases you risk being out of the market.

What is important is with contract rolls approaching, a lot of people are presented with the choice of what to do with their positions and the Index is now right in the region of where it posted a downside key reversal in March so there is scope for a pause to allow the short-term overbought condition to be unwound.

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