It appears as if FINRA (the Financial Industry Regulatory Authority) fined a few brokerage firms about $9.1 million for selling "non-traditional" ETFs to their more conservative clients. The funds in question are those inverse, double- and triple-leveraged funds that track indexes and commodities.
A $9.1 million fine seems like it would be petty cash to a big brokerage firm - especially if they were selling these funds to people who had no idea how they work.
For example, one of the settlement letters noted that a "65-year old conservative customer with a stated net worth under $50,000 held a Non-Traditional ETF for 43 days and sustained losses of over $25,000."
That's a big loss. It takes a lot of tracking error (or being on the wrong side of the market) to lose 50% in 45 days. And certainly a conservative customer shouldn't be trading options either. But more knowledgeable traders with a short-term outlook on market direction could use option spreads that create a fixed risk/reward profile.
Using SDS or SSO Options
For example, if you think the market could fall by a few percentage points by May 19, you might consider buying call options on the UltraShort S&P 500 ETF (NYSEARCA:SDS). This fund is designed to provide a an inverse 2X return on the S&P 500.
But you could also buy put options on the opposite non-inverse fund, the Ultra S&P 500 (NYSEARCA:SSO), which has a goal of delivering 2X the return of the S&P 500 index.
In both cases, I might consider a spread that has a maximum return if the S&P 500 falls by 3% by expiration. So here are two trades to consider:
- With SDS (the bearish fund) at 15.00 as of the close on May 1:
Buy the May SDS 15 strike calls
Sell the May 16 strike calls
Net debit of 25 cents - or $1,000 for 40 contracts
- With SSO (the bullish fund) at 58.14 as of the close on May 1:
Buy the May SSO 58 puts
Sell the May SSO 54 puts
Net debit of 99 cents - or $990 for 10 contracts
Which would work best? The results would be almost identical.
Here's a chart showing the theoretical profit and loss for the both spreads. Note that the axis at the bottom represents the movement in the S&P 500, not the price of the ETFs themselves.
As you can see, breakeven at expiration would be if the S&P 500 went down by about 1%.
For SDS, this would mean the fund would trade up 30 cents to 15.30. That's a 2% move. So the long 15-strike calls would be worth about 30 cents, or a slight profit on the initial cost.
For SSO, the breakeven is roughly the same. If SSO fell by 2% (twice the 1% fall in the S&P) to around 57, the long 58-strike puts would be worth about $1, about what was paid for the spread.
The maximum return for SDS would be if the fund rose by around 6% (a 3% drop in the S&P 500). That would mean SDS would rise to about 15.90, which is just shy of the short 16-strike call. For SSO, that same move would mean the fund would fall to 54.65, which is pretty close to the short 54-strike put.
There's a few slight differences, but the charts are virtually identical.
So which is better? Sometimes you might find a pricing discrepancy that gives you a slightly better deal on one or the other, but if not, I'd probably go with SSO.
Just given the price characteristics of these ETFs, SSO has more strikes available to choose from. The difference between a 58 put and a 57 put amounts to less than 2%. But with SDS, you're pretty much limited to the at-the-money 15 strike and the 16 strike which is more than 6% away.
That means SSO gives you additional nuances in the way you can trade a spread. I will point out, however, that SSO options are a bit less liquid, although there are more than 1,000 contracts outstanding for the strike prices shown in the chart.
Also note that implied volatility will almost certainly rise if the market does fall. This would reduce the value of the spread if you wanted to exit with a profit before expiration, but it makes no difference at expiration.
As for tracking error? That's possible, but my example shows a short-term trades of less than 3 weeks. That makes tracking error a lot less likely to be much of a factor. And the advantage to the an option spreads is that your risk is limited solely to the debit paid for the spread -- which I hope would not represent a 50% loss to your account.
I'm not calling for the market to fall apart by mid-May, but if you are, perhaps you should consider one of these two option spreads.
Oh, and if you want to take the opposite view, that the market goes up, you can buy SSO calls or SDS puts. They'd probably work out about the same, too.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.