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Due to the recent downturn in the markets, I have been approached by several friends and family members asking me for advice on shorting the markets. I recommend shorting through ETFs. Why? Because shorting individual stocks right now can be very risky – a new product offering or a potential acquisition can cause a individual stock to skyrocket in what is otherwise a downwardly trending market. If you are looking for additional risk, you can find this through leveraged ETFs, but there are some things you need to be aware of so that you aren't taking on more risk than you planned.

Liquidity

With the large number of new ETF offerings over the past few years there are options to short virtually any index you choose, sometimes with double or even triple leverage built in. Since there are so many ETFs out there to choose from, some of them are pretty thinly traded and make liquidity a big concern. As an example of this, the ProShares UltraShort (2x) Nasdaq Biotech ETF (NASDAQ:BIS) has a three month average daily volume ("ADV") of 1,489 shares. ProShares UltraShort Industrials (NYSEARCA:SIJ) is only slightly better with an ADV of 41k shares. Low volume means large bid/ask spreads and a large position moving in or out of the ETF could move the price significantly.

Decay

The second problem is decay. Decay only occurs in leveraged ETFs and in volatile markets. If the market goes up 1% one day and then back down 1% the following day and this repeats, a leveraged ETF will actually lose value over time due to the compounding nature of its leverage. It can be difficult to understand, so I built a spreadsheet to replicate this. After 10 weeks of simulated trading (one day down 1%, next day up 1%, repeat) a 2x leveraged ETF loses 1.5% and a 3x leveraged ETF loses 3% even though the underlying index ends flat (for the mathematicians out there, yes, I adjusted the final day to make the index end flat). It doesn't matter if you alternate the days or if you have 15 days in a row one direction followed by 15 days the other direction, the decay is the same. Decay is exaggerated even more when you have larger daily moves in the underlying index.

There is a corollary to this though. If you have a trending market you can get compounded returns. For example, a market that goes down 1% a day for 10 days in a row is down only 9.56% from its starting point, yet a 2x leveraged short ETF is up 21.9% and a 3x leveraged short ETF is up 34.4%. If you run this same formula out for 50 days, the underlying index would be down roughly 40%, but a 3x leveraged short ETF would be up an astounding 338%!

Although the compounding effect looks tempting, markets almost never go in a straight line and history shows us that due to market volatility, decay ends up trumping compounding returns given any reasonable period of time. A perfect example of this was during the financial crisis of late '08 – early '09. Direxion has a 3x leveraged Financial Services short ETF (NYSEARCA:FAZ). If you had purchased FAZ in November '08 when the financial companies really started tanking and held it until March '09 when the Financials were at their lowest, you would have lost money on the trade. Split adjusted, FAZ closed at $1,654.80 on November 20 2008 and $991.70 on March 9, 2009, even though the underlying index (the Russell 1000 Financial Services Index - $RIFIN) dropped over 25% during the same time period. You were both right and wrong. You picked the right direction, but you picked the wrong vehicle, so you ended up losing money.

Margin Requirements

FINRA (Financial Industry Regulatory Authority) put in place new margin requirements for leveraged ETFs in December 2009. Margin requirements are now increased in proportion to the leverage in the fund. For example, a short ETF (no leverage) has a margin requirement of 30%. Under the new rules, a 2x fund has a requirement of 60%, and a 3x has a requirement of 90%. I am not aware of any funds that have 4x leverage, but according to the formula provided by FINRA, such a fund would have a 120% margin requirement (not that this makes sense, just reading the rules!).

The important thing to note is that due to the higher margin requirements of the leveraged ETFs, you can't realistically get more than 3x leverage through the use of margin, but there are different ways of achieving this sort of margin. For example, if you wanted to get 3x leverage you could do so by buying three times as many shares of a non-leveraged ETF by using margin, you could buy 50% more shares of a 2x leveraged ETF with margin, or you could buy a 3x leveraged ETF. Although all three of these options result in you having 3x leverage, the risk and results of these three different strategies will be VERY different due to decay and/or compounding returns.

Conclusion

When evaluating how much leverage you wish to get in a fund, you should consider your time horizon. Due to decay, a 3x leveraged fund should only be used if you are certain that the market is going to be going down virtually every day during your time horizon. Since the market is volatile right now, hoping for more than 3-5 days of a downward market without any up days is not very realistic. The whipsawing of the markets back and forth can erode your profits in a 3x fund even if you are right. I try to steer people away from the 3x funds for this reason.

For liquidity reasons I prefer to stay with the big ETFs, such as SPY (non-leveraged S&P 500 index ETF), or SDS (2x inverse SPY). You can also trade the Nasdaq funds (QQQQ – 1x, or QID - inverse 2x).

Depending on your appetite for risk, if you wish to be short the markets through ETFs, shorting SPY is the safest and you will not experience any decay over time. Going long SDS (which gives you a negative 2x position on the S&P) provides you with the ability to earn compounded returns, but increases your risk due to having a leveraged position as well as having to deal with decay if it takes longer for the markets to drop than you expected.

Since I believe that the markets are going to drop over the next couple of months, I have chosen to be long SDS in order to benefit from compounded returns and I am using margin in my account to bring my total leverage up to around 2.5-3%. I am able to increase my exposure through a 2x fund and by using margin, yet reducing my risk of market volatility by doing it this way versus purchasing a 3x leveraged fund.

You will have to decide the best strategy for your needs depending on your appetite for risk and your time horizon for your investment. Although this article deals with shorting the markets, everything in this article applies to using leveraged funds to go long the markets as well (margin requirements are slightly different, 25%, 50%, and 75%). In general, I recommend that 3x funds not be played more than a few days, 2x funds no more than a few months, and non-leveraged funds can be played as long as you like. Decay can and has caused investors to lose money even when they picked the right side to be on. Nothing is worse than losing money when you are right. Be smart, understand how these leveraged funds work and you can get them to work for you.

Disclosure: Author is long SDS

Source: Shorting With ETFs: 3 Things to Consider