A Strategy To Profit From Leveraged ETF Decay

Includes: AGQ, SDS, SSO, ZSL
by: Bleecker Street Research

Shorting a leveraged ETF pair is an interesting concept, as it allows you to take advantage of the decay in these instruments. Any leveraged ETF seeks the double or triple the daily return of its underlying index. Since the ETFs seek to maintain a daily leverage of 2x or 3x, they have to automatically rebalance every day. This basically amounts to the fund having to buy on days when the market is up and sell when the market is down, and buying high and selling low is no way to invest. So how can you take advantage of this negative drift of leveraged ETFs? Well, you can short the pair. You would short the 2x long ETF and the 2X short ETF This gives you a nice low-risk balance with big potential for profit, as your short holding period increases, and you can truly begin to take advantage of the leveraged ETF decay.

Silver ETFs

Short both the ProShare UlraShort Silver (NYSEARCA:ZSL), which is 2x short silver, and the ProShares Silver (NYSEARCA:AGQ), which is 2x long silver. Both of these ETFs seek to double the returns of their index, in this case, silver (NYSEARCA:SLV). So if SLV was up 2%, you would expect the Ultra Short ETF to be down 4% and the long ETF to be up 4%. However, as I outlined above, leveraged ETFs have many problems and often end up underperforming. Here is how they have behaved so far in 2013.

SLV is up 3.6% YTD, so you would expect the UltraShort to be down 7.2 percent and the long ETF to be up 7.2 percent. Yet the UltraShort is down 9.1 % and the long ETF is up only 6.4%. If you had shorted the pair at the beginning of the year, you would have a return 2.66%, which isn't great considering the market has done so well, but it is a trade that works out better the longer you hold onto it, as the problems with leveraged ETFs add up. For example, here is a two year chart of the same ETFs.

Now we start to see the payoff from shorting the pair. If you had shorted the pair two years ago, you would be up 47.51%, not bad. However, these ETFs aren't meant to track SLV. They are indexed to the London Silver Fix Price, but the SLV holds silver and is benchmarked to the London Fix, so it is a good comparison. Over the last two years, SLV is up 8.2%, so you would expect the UltraShort to be down 16% and the long ETF to be up 16%, but as you can see, they did not exactly achieve their desired results.

I used Silver as the first example, because it is backed by a commodity, and everyone is relatively familiar with it. Here are the results if you had used leveraged ETFs to either short 2x the market or go long 2x the market (In this case the market is the S&P 500)

S&P500 ETFs

Short both the ProShares Ultra S&P 500 (NYSEARCA:SSO) and the ProShares UltraShort S&P 500 (NYSEARCA:SDS). Both of these ETFs seek to double the returns of the S&P500. So if the S&P500 is up 1% then the UltraShort will be down 2% and vice-versa. Here is how they have performed so far this year.

With the S&P500 up 6.42%, both ETFs have tracked fairly well with the UltraShort down 12% and the long Ultra ETF up just over 13%. The benefits of this strategy, however, are best realized when viewed over a longer period of time.

Over this time period, the S&P500 was up 15.80%. The long ETF performed admirably, up 31%, almost exactly doubling the return, but the UltraShort was down over 45%. If you had made this trade two years ago, then you would be up just over 14%, not as good as the previous ETF pair, but still not bad.

These type of trades perform best in two types of markets. A highly volatile market is good if you are shorting the pairs, because it increases the costs of these ETFs when they re-leverage every day. The other type of market that is good for this strategy is a relatively flat market. You want to avoid a market that has a strong trend in one direction. Also, it is important to remember that if you are shorting the S&P500 ETF pair the S&P500 is the market, but if you are shorting the Copper ETF pair, then it doesn't matter what S&P500 is doing, you need to be looking at copper prices.

The main drawback with this strategy is the potentially high borrowing cost to short the ETFs. If this is the case, you could always look into using LEAP options to execute this strategy. There are many ETF pairs that you can implement this strategy with, but remember, having a longer time horizon for this strategy gives it the chance to show its potential.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Author payment: Seeking Alpha pays for exclusive articles. Payment calculations are based on a combination of coverage area, popularity and quality.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here