Preparing to Hedge with UltraShort ETFs

Everyone takes a beating sometimes.

Ray Liotta's character Henry Hill in the movie 'Goodfellas'

I'm tired of taking a beating at the hands of the stock market these last few months. Although I've outperformed all indexes on a relative basis, my goal is absolute return. My gut tells me that I'm looking to hedge so the mid-January bottoms will hold here, making the last few days a successful retest. But, my mind and my models tell me otherwise.

While my most recent market outlook states that demand is in control and must be given the benefit of the doubt and that still remains the case as of the writing of this post, the NYSE Bullish Percentage is very close to signaling a reversal in favor of selling pressure. In fact, another day like Tuesday, and the reversal will have taken place. On February 28, 2008 the NYSE internals were >2:1 decliners to advancers and down volume to up volume, while the next day, decliners to advancers and down volume to up volume were >6:1. Two consecutive days such as these typically herald the beginning of 17 to 27 trading session selling stampedes. The beginnings of selling stampedes tend to take place near reversals to selling pressure being in control of the NYSE Bullish Percentage.

My models tell me that if we see the reversal to selling pressure being in control within the next few trading days, we should expect a bottom in the area between S&P 1210 and S&P 1240 sometime between the middle and end of April.

Therefore, once the seemingly imminent reversal in the NYSE Bullish Percentage takes place I will be implementing a hedge. My hedging vehicle of choice will be the UltraShort S&P500 ProShares (SDS). I plan to dedicate between 10% and 15% to the hedge leaving me 60% to 70% net long given that SDS seeks to replicate 2X the inverse performance of the S&P.

Given my net long exposure I would prefer not to make money on my hedge. But I'm afraid I will.

Comments

[Aviator:]

If your models are telling you that the S&P has at least a 100 points to lose to the downside, why are you net long? This is lunacy. You're throwing your money away. A conservative position would be short stocks or in cash. A rather reckless one would be long stocks with hedges. The trend is down -- don't argue with the tape.

2008 Mar 06 04:11 PM

[Paulo:]

Being a bit of a contrarian (but not always a bear) I am now worried by the stampede to SDS on the part of retail investors, hedge funds, and even institutional investors.
What I am worried about now is counterparty risk. I am starting to have doubts that massive numbers of lottery winners showing up on the third day of a crash like the one in 1987 (which I lived through but will stay on topic) will find a cashier at the wicket.
None of these ultrashorts have a track record of successfully paying off all the winners in something like a 1987 event.
Any good research out there on this??

2008 Mar 06 06:35 PM

[adan:]

paulo has a good point that's had me worried too (in re to holding one of the more thinly traded etf shorts)

i have the same question, any good research out there, yet? maybe too soon in their history?

also, what kind of volumn might a short etf need to help one feel better about counterparty risk? or would the risk always remain, esp in a free fall?

thanks ya'll

2008 Mar 07 08:15 AM

[Paulo:]

Okay, a great wall of silence.

Let me rephrase my question, are there scenarios in which an ultrashort can look like, walk like, and quack like a Ponzi scheme??

A Ph.D. or an M.B.A. (especially an M.B.A.) is not required to respond to this question.

2008 Mar 08 08:54 PM

[User 161949:]

OK, Paulo; I own the ProShares ultra-short real estate and Russell 2000 etf's, both double inverse, and I did have concerns about the solvency of ProShares. Answers were not readily forthcoming when I made inquiries, but I was told the company offers their funds and does not make its own bets. My thought is that this is not a ponzi scheme, but rather that the company buys the underlying investments that allow the funds to realize their double inverse relationship to the markets. The more shares are bought by the public, the more the company buys.
I, who worry about such things, am not worried about this. Maybe I should be, but I'm not.

2008 Mar 08 10:39 PM

[tomsmith:]

I have been looking into this for a short while. There appears to be no real study done on this, just us all worrying about it, and everyone else seems to be swallowing the company line about how it works well. Two fridays back, there was a serious discrepancy in how the sds tracked the spy, lets just say, it didnt. It did seem to right itself on monday and all thru this past week. Good luck to us all.

2008 Mar 08 11:09 PM

[tomsmith:]

I should have added, that since Nov 1, Ive tracked the double inverses by Proshares on an almost continuous basis. In comparisons with the underlying, in the oil etf and the spy x2 inverses, there was relatively decent tracking, the most that I recall on a daily basis was about one and a half percent variation from what its supposed to be as of Proshares. Personally, I dont trust proshares to be able to keep them together in a thousand point down dow in a few days, therefore, I would say, put your shorts on or use futures as a hedge, but this will all need to be done well in advance, and, dont expect to be able to get out of your shorts at the bottom .

2008 Mar 08 11:18 PM

[Rusty Shack...:]

Doesn't ProShares achieve it's inverse performance targets on it's ultrashort funds by leveraging futures? If so, isn't the counterparty failure risk the same if you're directly trading futures? If you're worried about a risk that ProFunds might experience a company-specific problem or failure, aren't there other inverse plays out there like iShares, ProFunds, Rydex, etc. that one could use to diversify against that risk?

2008 Mar 09 02:17 PM

[Kunst:]

I moved into ultrashorts from November to January. I am up 14.4% YTD. I am about to move out of SRS, as I think housing has largely already taken its hit (but commercial RE is another story). SKF (financials) has also had quite a run, but I think that story has several more dismal chapters to write. I think China is a leakinng bubble -- FXP is a bet on that.

If you're a believer in passive (index) investing and you think we are in a bear (declining) market, ultrashorts are the place to be. Consider TWM, ultrashort Russell 2000.

The risk, as with any "investment", is that the market could go opposite to what you expect. I was up 17.3% YTD on January 18; that was down to 1.2% by February 27.

2008 Mar 09 05:40 PM