Financial ETFs Show the Trouble with Trading Ranges

My old friend, Michael, has been watching the rally for signs of exhaustion or continuation with an eye on trading Direxion's 3x/-3x financial sector ETFs, symbols FAS and FAZ respectively.

Last Friday, he wrote about FAS that it "looks like a classic range rider pattern to me. If so, and if it isn't over, the next stop is $13.50 followed by a dip to around $10." He noted that "it could be getting a bit long in the tooth." Here's the chart he sent with those comments: [click images to enlarge]


Based on that, Michael went long FAS, enjoyed Monday's fat 18% gain, and sent me this follow-up:

Today went as predicted by the pattern in the chart. I'm very short term, and could be switching horses as soon as tomorrow, although that would be quick for the pattern to hit a top. I do expect a downturn after the spike we are seeing now, even if the uptrend continues. This rally has been ziggy zaggy all along. With an 18% day today I'm leaning toward a hair trigger...and I have a healthy chunk of change in reserve too.

Catching an 18% day is a fine piece of work for a trader. If we expand the view, however, we can see that a longer term and a proper swing trade results in less trading and more profit per trade. That same FAS, for instance, would have produced a 375% gain from its March 6 low to its May 8 high. That would have been perfect, which nobody ever pulls off, but even cutting away the extreme points on the range leaves a lot of room for big profits.

Which brings us to the trouble with ranges. What did FAS's trading range tell you down to the March low? Have a look at the early February to early March range:

Connecting the Feb. 9 and 26 peaks with a straight line told you that the top of the downtrend range fell at about $3.73, which FAS hit on March 10. That was when range trading told you to get out, but was precisely when you should have either gotten in or already been in and held tight for the rally ahead.

Which is why I wrote back to Michael:

One thing to keep in mind with ranges is that their most profitable moments happen when they stop working -- and unfortunately that profit comes only after you somehow know that what the range has been saying repeatedly no longer applies. In other words, the range is most profitable when it's finally wrong. At the break out or break down moment, the range will say to sell just when the up move will accelerate or buy just when the plunge gets out of hand.

That doesn't make trend analysis useless, but does give it the same hazy quality as all other market methods. Personally, I've come to find trends best when I disagree with them and think that their end is imminent and that the time for going against the grain has arrived.

To which he replied, "Agreed. There is a truism here: range riding works until it doesn't. And typically it takes most of the life of a range to have enough data to identify the pattern. Once that pattern is well enough defined to recognize, there is usually only a limited life expectancy before the until it doesn't phase. I agree with you that we are probably nearing that point on this one."

Comments

[AndrewBaker:]

It's dangerous using technical analysis (charts) on a 3x leveraged instrument as the movements are not linear, so the chart is not a truse reflection of the action of the underlying security(ies). The relationship between one day's price and another in these cases is exponential.

Example: XXX starts the day at $10, and the underlying index falls from 100 by 5%, being a level of 95, and meaning XXX ends day 1 at $8.50. The next day the underlying index closes 5.264% up at 100 again: which means that XXX closes at $9.84, not the $10 it started at the day before. Extrapolate that over a few more days and see how the chart will vary from the underlying. So I always look at the underlying chart too on the occasions where I find myself trading over two or more days 3x (or even 2x) leveraged.

Holding 3x ETF over more than a day or a few at best is very dangerous. One day against you where the market falls 10% requires a 14.33% market gain after just to get back even, which translates to a 43% gain for the ETF. In money terms, a $10,000 bet falls to $7,000 on a 10% day's drop, which the financials have done more than once this year (and this includes long and short, so the recent rally would have had this result for a bear shorting at 3x.)

For all that, I enjoy it; and good luck to all those others in there too!

May 20 12:12 PM

[Alan Young:]

Using a triple-leveraged fund to follow a trend for 10 weeks? Yes, it would have been a perfect investment, were you blessed with hindsight to do it. Using foresight and available data in real time, you'd have to be crazy to take this kind of risk. A leveraged fund is a derivative product, whose value changes arbitrarily based on an underlying index. You can't do proper T/A on a derivative, only on a real index (or a product that tracks it directly, like XLF).

If you're making a point about how to trade, rather than wishful thinking about how much money you could have made if you'd guessed right, please use a realistic example.

May 20 01:10 PM

[one eye:]

I use a 10 day chart with a 5 min. sma.

May 20 04:30 PM

[carey_jim:]

The ETF's don't accurately reflect the value of the underlying stocks either, whether they are leveraged or not.

Someone has probably got a published list of the underlying stocks that ProShares ETF's are invested in and it would be interesting to look at the 1x, 2x and 3x funds and graph the results of a comparison of underlying stocks with the funds, over various periods.

I think the very high volume and sometimes forced liquidations cause dog to wag tail and sometimes the inverse ;)

It doesn't mean they aren't exciting gambling vehicles. They've got the lottery beat by a long way in that department If you are very young, or very old without heirs, and just like to have fun .... or if you are playing with five percent of your net worth ... good luck and have fun gambling.

May 20 07:51 PM

[predictorma...:]

I am holding TZA and TYP waiting for the drop. So far I am about even for two weeks (I was well ahead until Monday). It' an experiment and so far working in range bound trading.

I like the thrill of the 3x but the temptation to take profits after a quick run up is strong and you can miss the giant gains.

I bought EDC and took a quick 25% selling at 52. Now a few short weeks later it's at 80 something.

These are much better than FAZ, FAS or SRS. I don't think any of these are playing on a level field.

May 20 08:20 PM

[ConcreteJungle:]

Its crystal clear from looking at the historical combined price on the FAS/FAS combo (and understanding just a little about how they work) that the decay built into the funds will inevitably squeeze out all the value from holding a long position on the pair.

However is the downward trend slowing? If it is, then buying an equal value of FAS and FAZ and selling upside calls may have potential.

The daily swings of 10%+ keep option prices quite high. By continuing to adjust the combo position to be equal in dollar value terms (after price dislocations and option assignments for instance) while immediately selling more calls *might* be able to beat the decay of the underlying position. I wonder how to do the analysis on this??

May 21 10:46 PM

[roger.wan:]

faz sucks. never goes up. how can you imaging the price of FAZ free fall from 200 to 4 USD? Any thing happened before Mar.9? nothing! Who can explain this to me? The Dow is going down but FAZ is still going down.... Can you imagine that?

May 22 09:46 PM

[eyt:]

It the very likely trend for the 3X (such as FAS or FAZ) is moving lower, is it a sure bet to short both of them? Anyone has tried that?


On May 20 12:12 PM AndrewBaker wrote:

> It's dangerous using technical analysis (charts) on a 3x leveraged
> instrument as the movements are not linear, so the chart is not a
> truse reflection of the action of the underlying security(ies).
> The relationship between one day's price and another in these cases
> is exponential.
>
> Example: XXX starts the day at $10, and the underlying index falls
> from 100 by 5%, being a level of 95, and meaning XXX ends day 1 at
> $8.50. The next day the underlying index closes 5.264% up at 100
> again: which means that XXX closes at $9.84, not the $10 it started
> at the day before. Extrapolate that over a few more days and see
> how the chart will vary from the underlying. So I always look at
> the underlying chart too on the occasions where I find myself trading
> over two or more days 3x (or even 2x) leveraged.
>
> Holding 3x ETF over more than a day or a few at best is very dangerous.
> One day against you where the market falls 10% requires a 14.33%
> market gain after just to get back even, which translates to a 43%
> gain for the ETF. In money terms, a $10,000 bet falls to $7,000
> on a 10% day's drop, which the financials have done more than once
> this year (and this includes long and short, so the recent rally
> would have had this result for a bear shorting at 3x.)
>
> For all that, I enjoy it; and good luck to all those others in there
> too!

May 26 01:20 AM