Leveraged ETF’s can be a great way to make some good money. But there are risks associated with these ETF’s that are specific to them. That specific risk is called contango.
Leveraged ETF’s use futures contracts to achieve their multiple. They may use any number of futures to achieve this: oil, corn, mini’s, soy beans, etc. etc., the list goes on. But when using futures, there is a problem.
Contango is what happens when the leveraged ETF purchases front month futures, closes them out, and then purchase the next contract for more money. Example: Let’s say I buy a futures contract for $100. Later in the month I close that contract out, and purchase the next month’s futures for $101. Because that new contract cost $1 more, I can now buy 1% less than I could the previous month. No big deal, right? That’s just 1%. However, multiply that by 12 months and you are looking at a 12% loss annualized.
Contango can and will eat away your leveraged ETF gains.
Sometimes, the new contract purchased is cheaper, and that actually helps your ETF. This is called backwardation. Example: I purchase a futures contract for $100, and I sell that contract at the end of the month. I then purchase the next months contract for $99. I can now purchase 1% more. This helps the ETF and your position.
Leveraged ETF’s on the surface seem like a great thing when you are sure of the direction of that ETF. However, there are risks, like contango, that are real and can degrade your position pretty quickly.
It is my opinion that leveraged ETF’s are best suited for day trading or small swing trades. Holding leveraged ETF’s from month to month can be dangerous.