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By Dave Nadig

There may be no perfect volatility product on the market, but smart ETF investors can profit in trendless markets with a little fancy footwork.

I agree with Matt Hougan (shocking, I know) that the VIX isn’t a great way to actually invest in volatility—even if you could buy it in pure, unrefined form, which you can’t. But as always, the question investors should be asking themselves is: “What am I actually trying to do?”

If you ask most people why they’re interested in volatility, it’s not that they see volatility as a bad thing, period. It usually comes down to one of two things:

1) They’re trying to protect themselves from downside volatility.

2) They’re trying to profit from flat, volatile markets.

The first objective is the easiest one for a sophisticated investor to achieve, with or without ETFs. Worried that your portfolio is going to take a 20 percent drop in the next year? The options market has a fun little product called a “put” just for you. So-called suicide puts are cheap. With the S&P 500 SPDR (NYSEArca: SPY) trading at $119 as I type this, you can buy the right to sell your SPY for $100 in December for the rock-bottom insurance premium of about $3 a share.

Making money in a flat market, however, is more complicated. Again, the options markets offer many ways to play this game. The easiest, perhaps, is just writing call options against your SPY position and pocketing the change.

But sophisticated ETF investors have another way to play this game: taking advantage of the compounding nature of leveraged and inverse funds. As we’ve covered here many times, one of the features—or problems, depending on your perspective—of most leveraged or inverse ETFs is that they provide a daily return. This results in giving you a compounding effect in trending markets, and a deterioration effect in trendless markets.

Just to reiterate it—here’s how the math works between a leveraged fund and a traditional fund:

Trendless Market

Market

2x Leveraged ETF

Normal ETF

Day 1

100

$100.00

$100.00

Day 2

110

10%

$120.00

$110.00

Day 3

100

-9%

$98.18

$100.00

In this worst case scenario, the 2x ETF investors lose about 2 percent of their money, even though the underlying index is completely flat over this hypothetical two-day period.

Most of the time, this gets covered in the financial press as a negative, because if you’re trying to achieve double the returns of the S&P 500, you need to constantly adjust your holdings.

But here’s the neat part—in a truly trendless market, you can short out that deterioration effect and effectively cash in on the volatility effect. A market-neutral bet might be to go short the 2x ETF, using something like the ProShares Ultra S&P 500 (NYSEArca: SSO), while taking a corresponding long position in the S&P 500 with SPY. Such a strategy, on a daily basis, is market neutral. But over any trendless period, the value of that short position will deteriorate (in your favor) while your market position remains flat.

The months surrounding the March 9 bottom last year provide a perfect example of how this works:

SSO vs. SPY 10/29/08 - 6/30/09

Overall, in the period before, during and after the crash, the market was flat, despite a hair-raising drop of 25 percent. The long/short investor would have pocketed 10 percent, effectively profiting from the trendless, volatile nature of the period. Plays like this probably explain the substantial short positions you see in many leveraged and inverse ETFs.

The caveat here, and it’s a big one, is that trending has a much, much greater impact on the buy-and-hold performance of leveraged and inverse ETFs than volatility. Consider the following two scenarios of both an upward and downward trending market:

Rising Market

Market

2x Leveraged ETF

Normal ETF

Day 1

100

$100.00

$100.00

Day 2

110

10%

$120.00

$110.00

Day 3

120

9%

$141.82

$120.00

Falling Market

Market

2x Leveraged ETF

Normal ETF

Day 1

100

$100.00

$100.00

Day 2

90

-10%

$80.00

$90.00

Day 3

80

-11%

$62.22

$80.00

In both cases here, the leveraged investor is actually better off than you’d think, given the meaning of “double long.” When the market rises, the leveraged investor would make an extra $1.82 more than a simple doubling of the market performance; in a falling market, the leveraged investor saved $2.22 versus an investor who simply doubled-down on a regular ETF.

These trends kill the shorting strategy. For example, here’s how this strategy would have performed during the highest volatility spike in memory, in fall of 2008.

SSO vs. SPY, 9/2/08 - 11/26/08

In this case, because the market was trending so strongly (down in this case), the volatility-extraction technique does nothing more than dance around market neutral, and suffers from the relative benefits of SSO’s compounding effect.

And one final note—these strategies obviously work in both directions. If you believe we’re headed for a strongly trending market, but aren’t sure in which direction, you can avoid making the market call by going short a traditional ETF and long the leveraged version. And of course, you can also do this with longs and shorts of both directions—shorting an inverse fund to get the long leg of the exposure, while shorting the traditional ETF to get the short end of the exposure.

Such strategies are neither for the faint of heart nor weak of mind.

Original post

Source: Capturing Trendless Volatility With ETFs