ETFs and Contango
After purchasing an ETF, you expect to participate in the fund’s returns in the form of dividends and capital gains. The ETF provider intends to pay these distributions to you either by selling underlying shares of the securities in the fund or by selling specially created shares on your behalf.
Reaching this goal involves making several decisions. For example, the provider must determine the underlying securities in the fund, the ETF’s price and the timing and frequency for distributions. This approach requires the fund’s manager to decide whether he wants to own underlying shares of the fund’s securities or create unit trusts. All of these decisions involve choices of various types:
Which securities in the fund or ETF portfolio are going to be sold; what quantity of units will be sold in each distribution; how the ETF provider is going to support that sales commitment; and the timing of those sales commitments.
The way the Internal Revenue Service views these choices will differ if the ETF’s underlying securities are held in the form of unit trusts or held in the fund’s portfolio of underlying securities. The methodology for calculating the fund’s capital gains is used whether the fund’s underlying securities are in unit trusts or held in the portfolio.
When you are evaluating an ETF for either a trade or an investment, you should be aware of contango when determining the feasibility of a trade or position. Understanding how the contango could affect your trade or position will help you determine the best course of action. Most of the time, when an ETF trades at a price above the NAV, it's a sign that the fund is in a situation of contango. This can be the result of an imbalance between the fund's purchase and sale prices.
This is important to understand because it can have a significant impact on any trade or long-term investment, especially if you're trading options. Contango in an ETF impacts your trade or long-term investment in one of three ways, which are:
You are rolling long-term positions out at a loss because your cost basis on the secondary purchase is higher than the initial sale.
You are taking losses on the short-term positions because those positions are short-term.
You are accepting a loss on the options short put because the long put offset isn't enough to offset the cost of the initial purchase.