If you are an investor looking for some diversification within the commodities market or are just trying to capitalize on a recent rise in oil prices, you have probably heard of contango. This is a term from the futures market and it describes an issue commodity ETF traders should understand.

[VIDEO] Understanding Contango

Futures have expiration dates like stock options. It is also not uncommon for a futures contract with a longer expiration to cost more than a futures contract with a short expiration. Sometimes this increase in price is quite significant.

You can see a table showing each month’s futures prices for oil futures listed on the New York Mercantile Exchange here.

When that additional cost to move from one month’s futures contract to the next month’s expiration is much larger than normal traders say that the market is in “contango.”

This increases costs and can stunt your expected returns significantly. If you want to dig into the details and history of contango, check out this article.

In early 2009 the oil futures market had experienced extreme contango. This means that oil ETFs like DBO, USO or USL have underperformed oil spot prices by a wide margin.

This is aggravating to be sure but it does happen periodically. Many traders have lost interest in these commodity ETFs over this issue but is contango a conspiracy to rip you off or is it just one of the risks of trading commodities?

The bottom line is that contango is a risk, like any other. If the risk of contango in a specific commodity is beyond your tolerance then a broad based commodity ETF like DBC may be a better bet. Additionally, investing in an ETF of commodity stocks or those firms within sectors that could benefit from a rise in commodity prices may be an even better alternative.

The spread from one oil contract month to the next has normalized somewhat recently but it could flare up again and traders need to understand that this is a risk when dealing with most commodity futures or ETFs. However, the long term benefits of including some commodity exposure within a diversified portfolio are still very positive.

Image courtesy pray itno.