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Investing in Commodities, Tip 7: Rolling Front-Month Futures Is a Recipe for Disaster


Beware a front-month roll and how contango and backwardation impact it.

In recent years, utilizing exchange traded funds to gain access to commodities has become an increasingly popular method. Unfortunately, many of the most popular commodity ETPs utilize a front-month rolling strategy, which can lead to big losses for a position. The products that employ this strategy are known as "first generation" products, as they were the early entrants to the market.

A front-month roll implies that a fund invests in the nearest maturity futures contract of their respective commodity. At some point during the month, the fund will automatically sell out of its current contract and buy into the next nearest maturity (the front month) in order to avoid delivery, but this can create a big issue.

Contango is the process by which near month futures are cheaper than those expiring further into the future, creating an upward sloping curve for future prices over time. This means that the automatic roll process that these funds execute will sell low and buy high automatically. For example, say the current month's natural gas contract is trading for $1, the next month's is priced at $2, and the month after is priced at $3. This would be a contango pattern. In this example, an ETP that utilized the front-month roll would sell the current contract at $1 and buy the next at $2, instantly erasing value. This process can last for months depending on the state of a futures curve.

Luckily, there are a number of ways to avoid this issue. There are now a wide variety of ETPs that aim to eliminate contango through a wide variety of strategies that can save investors some serious cash.

Bottom Line: Beware of a front-month roll and how contango and backwardation will impact it.

This article is part of the series "Tips for Investing in Commodities." See also:

Tip 1: Futures Do Not Equal Spot

Tip 2: Commodities and Dividends Can Align

Tip 3: Watch Your Tax Rates

Tip 4: China Can Make or Break You

Tip 5: Low Inventories Can Lead to Backwardation

Tip 6: Diversification Is Not a Given

Tip 8: More Than Just Energy and Gold

Tip 9: Watch Out for That K-1!

Tip 10: Consider Expenses Always

Tip 11: Commodity Exposure Through Stocks: Pros & Cons

Tip 12: Know What You're Getting Into

Tip 13: Consider Physical Exposure

Tip 14: Commodity ETFs: Structure Matters

Tip 15: Bigger Does Not Mean Better

Tip 16: Commodity ETFs Get a Bad Rap

Tip 17: Beware the Dollar's Impact

Tip 17: Beware the Dollar's Impact

Tip 18: Not All Commodities Are Created Equal

Tip 19: Know Your Geography

Tip 20: Be Mindful of Your Timing

Tip 21: Platinum and Palladium Are the Other Precious Metals

Tip 22: Consider the COT Report

Tip 23: Remember That You Also Have Options

Tip 24: NAGS Vs. UNG -- Different Tools for Different Objectives

Tip 25: Free Resources Can Make Your Life Easier

Follow us on Twitter @CommodityHQ!

Editor's note: This article by Jared Cummans was originally published on Commodity HQ.
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