Monthly Archives: February 2014

Following FINRA’s changes to the Series 7 Content Outline in late 2011, exchange-traded notes (ETNs) became a topic that is a potential test item students may see on their exam. You can read more about ETNs in our Study Manual, but let’s visit them briefly here.

Essentially, an ETN is an unsecured debt obligation that may be worth much more at maturity than its purchase price depending on the performance of the assets or index to which it is linked. The dealer adjusts the intraday and closing indicative values based on the performance of the linked index. The market price often closely tracks that value, although there may be variations based on supply and demand. Unlike an exchange-traded fund (ETF) that is subject only to market risk, ETNs are subject to both market risk and credit risk. The price of an ETN will also reflect the credit quality of its issuer. As a result, an investor must review the liquidity of any given ETN as well.

Although ETNs must be registered under the Securities Act of 1933, they are not classified as investment companies. They are structured products that contain a debt obligation of the issuer that is linked to an index that represents a basket of stocks, bonds, commodities, interest rates, volatility, master limited partnerships, private equity, or metals. Derivative contracts are employed to provide the linked returns. An investor’s return is based on the performance of the underlying index, and ETNs are not principal-protected. If returns on the index are meager or nonexistent and fees outweigh appreciation, it is possible for the investor to experience a negative rate of return.

As with ETFs, ETNs can be leveraged or nonleveraged, inverse and noninverse. Those that are nonleveraged mirror the performance of the linked index. Those that are leveraged can return two or three times the return of the linked index. The values of inverse ETNs and inverse leveraged ETNs move in the opposite direction of the linked index. Similar to leveraged and inverse leveraged ETFs, leveraged ETNs are rebalanced daily or monthly and are best suited for short-term trading and not buy-and-hold strategies. They are not suitable for long-term investors because the daily or monthly rebalancing of leverage could result in the leveraged compounding of losses.

ETNs can experience large price swings when issuers increase or decrease the creation of notes. For example, if an issuer stops creating a popular ETN, demand may outstrip supply, causing prices to rise. When the issuer begins creating notes again, supply will increase, causing the ETN’s price to decline.  Investors who bought the ETN at its elevated price may experience a loss if they need to liquidate their holdings at the subsequent depressed prices.

Unlike ETFs, ETNs can be called at the discretion of the issuer. If an issuer finds that a particular issue or group of issues lacks investor interest, the issuer might call the ETN. Investors receive the ETN’s indicative value, based on the performance of the linked index less fees. This may result in a gain or a loss depending on the ETN’s purchase price.

While FINRA does not state how many questions may appear on a given topic, we believe that you should be prepared to answer a small number of questions about ETNs.

Thanks for spending time with us. We hope you found it worthwhile.

—Securities Training Corporation

As an instructor, there are some concepts that are more difficult to explain than others. Because time is limited, advanced concepts that aren’t heavily tested are compressed. In Series 3, contango and backwardation markets are a good example. Today, we’ll attempt to give contango a more robust explanation than we would in class.

Contango doesn’t even sound like English, and it’s never been entirely clear to me whether it’s a noun or a verb. Contango is actually a mispronunciation of the word continuation. Simply stated, a market is in contango when the forward or futures price is higher than the spot (cash) price. In a contango market, the further you continue along the forward curve, the higher the prices are.

A market in backwardation has a higher cash price, with futures going progressively lower. Since most of the time markets are in contango, the term backwardation, which is the opposite of contango, comes from the idea that the market is abnormal or backward. So far so good, and if you’re just looking for answers to questions on your exam, this is the extent of what will be asked. But we promised a robust explanation, so let’s continue.

As we’ve said, a market is in contango when futures prices are higher than spot prices. So, what causes it? The futures premium is usually caused by the costs of holding onto the commodity. This is known as the cost of carry. For example, if I own 20,000 bushels of wheat, I’ll need to put it somewhere. It’s not going to fit into my apartment, so I’ll have to pay storage costs plus insurance and financing (i.e., carrying charges). What if I bought a futures or forward contract instead? Well, I wouldn’t have to worry about storing anything until delivery, which is typically preferable.

Predictably, the convenience of owning futures over the spot (cash) commodities causes futures prices to rise above the spot price and, before you know it, you have a contango market. The further into the future you look, the higher futures prices will be. The comparison of near and far delivery futures contracts is known as the forward curve. In a contango market, the forward curve is positive (i.e., upward sloping).

If a market is in contango, what will happen to prices in a few months? As students of commodities know, the spot (cash) price and the futures (forward) price must be the same upon the arrival of the delivery month. If they’re not, traders can arbitrage the difference, which will drive the prices closer anyway. In a contango market, either futures prices must fall or cash prices must rise as the delivery month approaches. So, which is it?

Historically, the futures prices will fall to meet the spot price as the delivery month approaches. This has been a problem for investors that bought commodity ETFs, which are typically long futures, not the spot commodity. As delivery nears, futures prices fall and the ETFs lose money, even if the underlying cash price isn’t moving at all. Most ETFs have the option to choose whether they buy futures or the cash commodity, which makes it difficult for retail investors to know the risks of an ETF portfolio at any given time.

Profits can be made in a contango market by those holding the cash commodity. Assuming we had a spare oil tanker lying around, we could buy spot crude oil and sell futures. As the delilvery month approaches, we will profit on our futures position as the futures price falls, and we deliver the oil in the tanker. In some instances, there has been more oil in tankers just sitting around in a contango trade, than actually being sent somewhere. This type of contango trade will be profitable, as long as the futures premium keeps exceeding the cost of carry.

If contango is normal, then what causes the market to be abnormal? The short answer is a shortage of the cash commodity or a spike in demand. Under these conditions, the futures price will be lower than the spot price, which is called backwardation. In fact, the longer delilvery contracts will have lower prices than the near-month contracts. This means that the forward curve is negative (i.e., downward sloping).

Just as in a contango market, futures prices and cash prices must meet at the time of delivery. In backwardation, futures prices tend to rise to meet the cash price as the delivery month approaches, which is similar to how futures prices fall as the delivery month approaches in a contango market. This means that long futures positions will tend to profit and short positions will tend to lose. This can be especially problematic for producers of a commodity such as farmers, who sell futures to hedge. Profits can be made in backwardation by buying long-dated futures and then selling in the cash market at delivery. Some traders will also buy long-dated futures and sell near-dated futures, which is called a calendar spread.

Thanks for spending time with us. We hope you found it worthwhile.

-Securities Training Corporation