Make Money in a Flat, Volatile Market by Short Selling Leveraged ETFs 23 comments
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I’ve been tossing this idea around on a few other blogs in passing so I thought I might as well post the mechanics and explanation of it here. First some background info to make sure we’re all on the same page:
Flat Market - Also could be called a sideways market. Normally the definition is a market in which prices change little, so I threw in an added caveat: a volatile flat market. This would imply prices change quite a bit from day to day, but overall the prices are relatively flat over longer periods of time (i.e. the market goes up for a stretch, down for the next, up again, down again, etc.).
Leveraged ETFs - These are Exchange Traded Funds that track an index with built in leverage. The most popular have a 200% daily exposure to the market. If the index went up 1%, the 200% leveraged ETF would go up 2%. Leveraged ETFs normally come in two flavours: Bull and Bear (or regular and inverse). The “bear” or “inverse” leveraged ETF will provide leveraged exposure in the opposite direction of the index. So if the index GOES UP 1%, you would LOSE 2% with a 200% bear etf.
The problem with leveraged ETFs is that most people don’t understand how they work. I’ll cut to the chase (but you can read here for more detailed info). The initial 200% exposure (or whatever the case may be according to the fund’s mandate) is based on tracking the daily movement of the index. It falls apart when you hold it for longer periods of time (in terms of providing a 200% constant exposure). Here’s a basic example of how this would work:
Let’s say your ETF is trading at $100.00/share and it is a 200% leveraged bull ETF. Your index goes up 10% on the first day, therefore your ETF goes up 20%. The ETF now trades at $120.00/share. Let’s say the next day the index goes down 10%, therefore your ETF goes down 20% again as well. EXCEPT this time 20% is of $120.00/share which is $24.00/share, leaving you with $96.00/share.
Think about this: the index was down 1% over the two days, yet your ETF has lost 4%.
If you want more proof as to how holding leveraged ETFs can be a losing proposition in volatile markets, look no further than the calendar year performance for 2008 of Horizon BetaPro’s Global Gold Bull+ AND Global Gold Bear+ ETFs: -44.56% and -84.47%, respectively. This is not a knock on Horizon BetaPro - their products do what they are supposed to do brilliantly.
In any case, if you had shorted either of those Bull or Bear 200% leveraged ETFs, you would’ve been a very happy camper (e.g. your 2008 returns would’ve been closer to +80% and +500% respectively). In a sideways market with even modest volatility, the bull and bear leveraged ETFs’ values will slowly erode. Therefore, if you short them you could make money in a flat or sideways market.
According to Horizons BetaPro (according to a report by Morningstar Canada), if an index was flat over a year with 25% volatility then you would lose 6.1% (before fees), 50% volatility would incur a loss of 22.1% (before fees). Once you further subtract fees, it only looks better for the leveraged ETF short seller.
To make money holding leveraged ETFs you have to be right both in the direction and the path of the underlying index.
Disclosure: I periodically trade leveraged ETFs, my only current position is EDC.
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I use etrade and, to test how it's done, I just tried to short sell a relatively small number of AGA shares. I was rejected because "Short sales in this security are not allowed, as we were unable to borrow the shares."
Do I need to work with another online brokerage? Does anyone know of one that will allow short selling of AGA or AGZ?
It's more akin to me saying "owning a broad market ETF works in an up market" without calling the market - I'm more of a passive investor for the bulk of my own portfolio.
On May 22 08:58 AM Luck-o-the-Irish wrote:
> This is true, but if you are short, and you are wrong, let's say
> you shorted FAS back in March, you could wind up with a loss of 100%
> or 200% in a rather quick fashion. Right now, we certainly have
> the volatility, but until the last week, we have only seen trends.
> The first went straight down in February, early March, then we saw
> the reverse in March-April, on the straight up path. If you had
> been too aggressive on either, and it was too large a percentage
> of your portfolio, you would have been wiped out. That does not
> invalid your point, but you fail to talk about ANY of the risks associated
> with this strategy at all.
> Secondly, you have to worry about the inventory issue. First, you
> have to find the shares to short. Then, and most importantly, you
> have to be able to HOLD your inventory. You completely fail to mention
> the buy in risk on these, and it is a major risk. You would not
> be a happy camper if you short one of these, the market moves against
> you, and then you are forced to buy at a higher price, and there
> is no inventory to short. You may very well have been right in your
> short, but you are given the time to wait it out, and instead forced
> to take a loss.
> I applaud you on the concept. It is a valid premise, but your failure
> to examine the risks is a pure shame.
On May 22 09:33 AM j1d2j3 wrote:
> this is true for any per-centage move; if %'s are equal, up and then
> down or the reverse ; the second move never numerically equals the
> first move. try it yourself , don't understand your point.
On May 22 10:54 AM jgbooker wrote:
> How do you make 500% on a short sale?
So you could call them and ask if that security is ever short-eligible, and also factor this into your decision to engage in this kind of strategy.
I might try it out myself in a small dose just to see how it behaves, but I don't think I would ever devote any significant allocation to it myself.
On May 22 11:00 AM D. McHattie wrote:
> I like the idea and think your reasoning is sound. Can someone help
> me with the specifics of this?
>
> I use etrade and, to test how it's done, I just tried to short sell
> a relatively small number of AGA shares. I was rejected because
> "Short sales in this security are not allowed, as we were unable
> to borrow the shares."
>
> Do I need to work with another online brokerage? Does anyone know
> of one that will allow short selling of AGA or AGZ?
On May 22 11:53 AM juan77 wrote:
> Buying puts is probably a cheaper and less riskier way to play this.
>
On May 22 03:06 PM inflation wrote:
> Preet - I assume this is what they refer to when they talk about
> the "decay" factor in the 2x and 3x etf's? I have seen decay mentioned
> many times on different blogs but was never exactly sure what it
> meant. I have been banging away on FAZ and FAS but never hold them
> for more than a day at a time. Usually just try to catch the trend
> of the day and get in and out quickly.
People misunderstand that EVERY investment is path dependent, if you double your money every day for 20 years and then go down 100% in one day you are left with nothing.
> @dumbo - I personally passively invest about 80% of my own portfolio,
> and I use up to 20% for my "trading account/gambling account". I
> say "trading/gambling" because I for the most part I don't try to
> predict the markets. This post was really just thinking out loud.
> I do not know of any volatility indicators that are forward looking,
> so the call for a flat market or volatility are just guesses in my
> opinion.
If you had given me some specifics, I would have backtested the concept and given you the results. Anyway, the concept of volatility-related loss in the leveraged ETFs is now fairly well known so you are not exactly breaking new ground. The problem is that flat markets often only become evident in hindsight so its difficult to trade forward based on the concept.
======================...
You mentioned in another reply above that since $1 to $6 translates to 500% gain on long side, thus $6 -> $1 move translates to 500% gain on short side. That's rubbish. The maximum you can make shorting a stock is 100%, and only if it goes to zero.
======================...
Lastly, it should be mentioned that even if one could borrow some of these ETFs for shorting, you would likely incur a much higher than normal "borrow cost" (atleast as a retail investor). The current borrow cost for shorting FAS at IB is about 15% (annualized) and was almost 30% just 2 weeks back; that's more than those (criminally high) credit card rates! Since no one (to my knowledge) on these forums has discussed this borrowing cost, it tells me they are mostly paper traders with little real-life trading experience.
It does work in practical application but there are two issues which reduce profits. The first issue is that one has to balance the positions on average once a week to keep them within shouting distance of each other. This adds significant overhead in the form of transaction fees. The second issue is simply trying to find enough SKF shares to short. SKF's high turn-over is far greater then shares held from day to day.
In anycase, shorting both the long and the short version of the fund and also keeping the two positions balanced removes nearly all the risk from the equation. I went net-positive after about a month of action and due to the way decay works both my positions are probably going to go positive next month. The theoretical return (if the market stays reasonably volatile) is about 50% a year. More realistically I do not expect more then 25% a year due to the overhead of having to constantly rebalance the positions.
Buying options on ultra funds is a fool's errand. I do not recommend it. That would be a derivative on a derivative on a derivative... total stupidity if you ask me. Holding ultra funds long is also a fool's errand. There's no point to doing it unless one wants to throw his money away. It's go short the shares directly or not use the fund at all.
-Matt
On May 22 04:38 PM Mark Prouty wrote:
> You can never make more than 100% on a short sale in your example
> if you short 1 million shares @ 5 or 5 million and it goes down to
> $1 or a value of 1 million you have made $4 on $5 of "capital" so
> you made 80%. Your loss is infinite.
>
> People misunderstand that EVERY investment is path dependent, if
> you double your money every day for 20 years and then go down 100%
> in one day you are left with nothing.
I expect another big dip in June or July and am currently holding TZA and BGZ as well as a few other 1x-2x inverse ETFs. I'll be interested in seeing if I can time those correctly and immediately turn around and sell them and then short them when they peak.
This strategy seems more profitable but I don't see how it can actually happen. Leveraged ETFs tend to have narrow, unsustainable spikes that are almost guaranteed to be short-duration. In order for an options trade to work here, either the buyer or the seller would have to believe the spike can be sustained, and nobody's dumb enough to do that.
On May 23 07:54 AM jgbooker wrote:
> Yes, and that is why puts would work better here.
seekingalpha.com/artic...
On May 22 03:06 PM inflation wrote:
> Preet - I assume this is what they refer to when they talk about
> the "decay" factor in the 2x and 3x etf's? I have seen decay mentioned
> many times on different blogs but was never exactly sure what it
> meant. I have been banging away on FAZ and FAS but never hold them
> for more than a day at a time. Usually just try to catch the trend
> of the day and get in and out quickly.
The cost (at least here in Canada with one of my discount brokers) for borrowing inventory is prime + 1.5% which equals 3.75%. Any my broker has inventory on leveraged ETFs that are short eligible. This is with Questrade (only operates in Canada I believe).
Unlike a real stock which might go from, say, $100 to $5 yet still have the risk of going to $100 again, an ultra fund cannot do that without the underlying position going up (or down) by 2000%. This means you can short more as the value goes down without increasing your risk relative to the risk of your original position.
Which, when you squeeze it all out, means you can keep shorting forever.
I still recommend hedging the short to reduce the risk further, though, by shorting the opposite ultra fund as well. And, of course, since these are complex derivative products there is no guarantee that the fund itself won't go haywire and do something it isn't supposed to do.
-Matt
Thanks
Ben