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US Equity markets made a mammoth move on Monday March 23, 2009 in response to the unveiling of Secretary Geithner’s Public Private Investment Program to take legacy assets off the book of banks. The shares of financial companies made a big move with the Russell 1000 Financial Index (RIFIN) moving from 452.21 (Friday close) to 526.12 (Monday High). Investors often trade the financial sector of the market using Ultra ETFs especially the 3x leveraged FAS (Bullish) and FAZ (Bearish). There are some caveats to observe if you are brave enough to hold overnight positions in these ETFs.

Effect of Daily Compounding: Amplifying Parabolic Moves

The Ultra ETFs compound daily, i.e. the base for the price movement is reset after every trading day. On a day where the underlying index has already made a big move, this amplifies to the incremental percentage moves in the direction of the main impulse. On Monday, the base value for FAZ was Friday’s closing value of $35. As the RIFIN moved higher, each incremental dollar move up was reflected in an equivalent dollar amount move down in FAZ. Though each incremental dollar move up in RIFIN was a smaller instantaneous percentage move in RIFIN, the equivalent percentage move in FAZ kept on going up, as the value of FAZ kept on falling while the base for calculating the move remained the same.

The accompanying figure shows that RIFIN consolidated its initial big move up between 1:00PM and 2:30PM on Monday with its value range bound between 490 and 495. The 38 point move up to 490 (about 8.35%) caused FAZ to fall from 35 to 26.25, a 25% move in line with the expected return. In the afternoon RIFIN rallied from its base around 490 to a close of 525.05 (an incremental move of 7.15%). FAZ fell to a low of 19.05, an incremental move of 27.4% from the lunch base of 26.25 instead of 21.45% (3x the move in RIFIN from the lunch base). This is because the incremental change in FAZ is calculated using the closing value of 35 as a base, and not reset during the day, in spite of the large move.

click to enlarge

A trader going long FAZ in anticipation of a pull-back in RIFIN would have incurred acceleration in percentage losses as the FAZ went down at a much faster rate because of the high base value its delta moves were based on.

NAV Divergence

Because of the extreme moves in RIFIN, the difference between the NAV of FAZ and its market price at closing ($19.05) on Monday reached 75c, almost 4% more than the NAV of FAZ. Part of the difference reflects positioning by traders for a reversal; some other reflects the inability of arbitrage algorithms to keep up pace with a very fast moving market and index composed of 227 stocks with different diverse capitalization and liquidity, almost all moving in the same direction.

To add insult to the injury, after the pull-back in RIFIN Tuesday, FAZ closed with a market value (21.15) which was 69c (about 3%) less than the NAV of 21.84 as traders positioned themselves for a bounce in RIFIN Wednesday. The swing in the difference between the NAV and the market price over the two days was $1.44 against a trader going long in FAZ, close to 7% of the price of the security.

A trader building positions in 3x levered ETFs should keep the above factors in mind, especially when positioning for a reversal after a big move. Perhaps it is best to use these instruments as day-trading instruments only!

Source: Some Caveats on Trading Ultra ETFs on Big Move Days