Short the Market with Options or ETFs?

Since it looks like the market will be handing us lemons for the foreseeable future, perhaps we could parlay this sour state of affairs into some sweet profits. There are many ways to play a bear market. Popular techniques include shorting the indices, buying index put options, and going long the short and ultrashort index ETFs. This last strategy is especially popular in retirement accounts.

We've looked at these strategies before in previous blogs (see 6/18/08 and 7/15/08) and thought it's time to compare them again since the market is much more volatile than it was last summer.

Strategy comparison

Here are the following strategies that I selected:

• Short the index tracking stocks: QQQQ, SPY, DIA
• Buy their short counterparts: PSQ, SH, DOG
• Buy their ultrashort (2x) counterparts: QID, SDS, DXD
• Buy March 2009 at-the-money (ATM) puts on the above tracking stocks
• Buy 2010 ATM puts on the tracking stocks
• Buy 2011 ATM puts on the tracking stocks

I wanted to look at a recent downturn so I choose the (relative) high peak put in on January 6th of this year and used March 5th closing prices. The table below summarizes the results.

Options still rule
The table reveals several interesting observations. The first is that buying the short ETF did better than shorting the underlying. (I've written before on the dangers of the short and leveraged funds (see 2/10/09 blog) so be aware that they may not perform in the way you think they should.)

The second observation is that instruments based on the S&P 500 and the Dow Industrials generally outperformed those based on the Nasdaq 100 (the Qs). Most likely this is due to the constituent makeup of each index.

The last observation is that short-term options trounced the returns of their LEAP counterparts. Using my handy-dandy Black-Scholes options calculator applet on my Blackberry, I found that the implied volatilities of the short term options are higher than that of the LEAPs, confirming my suspicion.

The effect of volatility

Before you race out and buy short-term puts, you should be aware that volatility is a double-edged sword. If you purchase an option in times of higher volatility, it's very possible that you can lose money if the volatility decreases, even if the market goes in your direction. To illustrate this point, I looked at the 2010 Jan90 put on the SPY. On 11/20/08, the VIX (market volatility index) hit a high of 80. That day, the S&P 500 closed at 752 and the put option at $27.15. Three months later on 2/26/09, the S&P again closed at 752 but the VIX had dropped to 45. What was the put worth? It closed at $22.15, 18% lower! The drop in value is due almost entirely to volatility as time decay is minimal for this LEAP.

Does this mean that you shouldn't take the options plays? Of course not! You can mitigate the volatility effect by using options spreads. A long put can be replaced by a bear-put debit spread where you buy the higher strike put and sell a lower strike put against it. One nice feature of this strategy is that your cost basis is decreased but it comes at the price of capping potential profits.

Cost basis

It's worth noting that not only do options offer you more leverage, but they're cheaper than buying the underlying instrument, giving you an extra bang for your buck. Plus, your risk is limited to the price of the option unlike shorting a stock which has potentially unlimited risk. However, if you've never traded options before I strongly urge you to learn about them and paper trade them first.

I hope this exercise has been instructive. That's the long and the short of it!

Comments

[squark62:]

good work. i trade primarily in my sep-ira retirement account so i don't trade options. so i quantitatively arbitrage ultralong and ultrashort ETFs for the S&P (SDS, SSO) and Dow (DXD, DDM). it's a slog but i've been gaining incremental profits this way despite the volatility. the quantitative analysis takes into account tracking errors and whether there's money to be made at all. pairing QID & QLD isn't working as well as the others, at least on paper. pairing DIG & DUG has been a disaster for anyone considering this approach. the last pair trade may work if oil gets above $50/barrel.

Mar 06 10:31 AM

[dumbo:]

A few points:
1) The price of SH on 1/6/09 was 69.60 (not 64.60). That would have given a gain till 3/5/09 of 32.3% (not 42.5%). I did not check the other prices; I assume they are OK.
2) Its interesting that the non-leveraged short equivalents of SPY and DIA (SH and DOG, respectively) gave gains (around 33%) that were better than shorting SPY or DIA (around 26%). Possible reasons may include greater than 1x leverage (it may be hard for the fund manager to be exactly -100% of the underlying), effect of dividends that have built up during this period, etc.
3) Such after-the-fact analyses, while instructive, should always be tempered by atleast 2 statements (which I don't see anywhere in the article): a) These results are of a hypothetical nature (and probably don't include the effect of commissions and slippage); and b) Had the opposite situation materialized (i.e. the markets had gone up instead of down) then the results would have been very different, especially for the options which would have yielded close to a 100% loss. The latter is very important for option trades as I see a lot of trader-wannabes on this forum who don't seem to ever analyze the what-if scenario from a contrary viewpoint.

Mar 06 12:29 PM

[ETFDesk dot...:]

This is great work. With all the attention of tracking errors with the 2x and 3x funds, i feel like options should be getting more attention. Kudos Dr. Kris.

ETFDesk.com

Mar 06 03:41 PM

[Dr. Kris:]

Dumbo,

You're right on the price of SH on 1/6/09. No, my analyses did not include commissions or slippage but it was designed as purely instructional.

Per your other criterion:

"Had the opposite situation materialized (i.e. the markets had gone up instead of down) then the results would have been very different, especially for the options which would have yielded close to a 100% loss. The latter is very important for option trades as I see a lot of trader-wannabes on this forum who don't seem to ever analyze the what-if scenario from a contrary viewpoint."

Well said.

Mar 08 03:21 AM

[LINDY77:]

Dr. Kris : Your article was good and helpful , however you did not show the possible gains by buying CALL OPTIONS on QID SDS or DXD . It seems to me this method would give the highest gain or loss as it adds the leverage from the options to the 2X from the ETF.
Do you think you could get the old option prices for at the money ask prices for these on the same dates you used in your study , so we can see if there is a higher gain or can you point me to a source for old option prices so I can figuer it out for myself. Thanks, Lindy
[e-mail]

Mar 08 01:45 PM

[donzelion:]

What about shorting the short ETFs?

Seems that their performance is ridiculously spiky, and given the effect of daily rebalancing, one need only wait for them to surge 5-10x, then short them and ride them back down again. (On the other hand, it may be that nobody thought of doing that last year, which is why they were able to spike so much...)

Mar 09 07:01 AM

[Ames Tiedeman:]

The average investor is much better off buying ETF's such as DXD, SRS, SDS, QID, FAZ, and SKF to short the market than to meddle with options. These ETF's are very easy to understand and to trade. Some of us think the time is quite right to own these now. The S&P 500 is in trouble. So goes the 500, so goes the entire market. You will not be safe anywhere when this cascades down...

Jun 22 05:53 PM