There is an interesting trade that has presented itself by utilizing both FAS and FAZ in combination, the Direxion 3x triple leveraged financial bull and bear ETFs. I thought I might share my thoughts on the application of this particular trade as primarily a hedging instrument and, secondarily, a speculative position.
Usually, pairs trades are sophisticated techniques applied by professional money managers, quant and hedge funds. They rarely justify the risk for retail traders because it will require you to be both long and short two corresponding positions with the intention to offset and neutralize risk. The problem is that what may be initially viewed as a balanced hedge, can ultimately force a nasty unwinding of the positions when both sides of the trade move against you. Disruptions and price dislocations in the marketplace, or the collapsing of risk arbitrage because of what seemed like a sure bet fell apart when the buyer walked away due to “material adverse change.”
Normally, I would prefer to hedge out the individual risk of each portfolio holding by utilizing a variety of put and call combinations, or even collars. While many seem to use indices as a type of broad based portfolio insurance, it can be rudely ineffective in terms of hedging individual stock holdings when matters of urgency are particular to one company outside the framework of overall market conditions.
Broad-based portfolio insurance may cover intraday swings and market corrections in normal behaving markets, but it is woefully inadequate and insufficient in covering downside losses of individual stocks. The obvious examples would be if you had thought you were covered with index insurance but held positions in companies like Lehman Brothers or Bear Stearns.
A Trade Too Good to Be True?
Whenever anything seems too good to be true, it often is. So what’s the catch, I ask myself? I began looking at this particular trade recently when the FAS and FAZ crossed in terms of price action, both trading in the $8 dollar range. It seemed like an appealing trade to capture the binary effect of the markets based on the ultimate success or failure of the financial banking sector.
You would have to assume that the design of both FAS and FAZ was to provide divergent instruments, both moving in opposite directions. However, due to extreme volatility and price dislocations in the markets since the fall of 2008, this financial crisis has presented opportunities that were unintentional. These ETFs were not designed to trade in tandem on a parallel course and trajectory rapidly approaching zero as they have recently. Interestingly enough, we now have a crisscross intersection of lines if you graph both positions to suggest extreme price dislocation.
Back in early March, I opted to enter a trade of writing naked equity puts which initiated my first entry on the FAS ETF. I didn’t buy the shares outright, but was willing to take in the premium by writing the risk of exercise. The trade worked well specific to the conditions of the market at the time and has remained on my radar since then waiting until opportunity presents itself.
As the markets continue to formulate a bottom and price action consolidates well above liquidation levels on most stocks deemed worthy to survive this financial debacle, there remains tremendous opportunity on valuation long before the p/e multiples and guiding metrics are allowed to expand into an inevitable recovering economy.
Because this trade seems almost too good to be true, I have to consider where the downside risk lies. One thing that immediately presents itself is that if you follow up on Direxion’s website, you’ll notice something very interesting. They plainly state that this 3x leveraged ETF is not designed for long term holders and, more specifically, it is intended to be more of a day trading instrument. In fact, they openly discuss investment goals determined by daily benchmarks. However, this was clearly calculated before the complete disruption in the marketplace and, therefore, even they could not have predicted where price action would have ultimately followed.
The other important thing to remember, especially with these 3x leveraged ETF products in particular, it is better to think of them as a cash settled instrument. Comparable to a futures contract with the additional benefit of not having to rely on specific timing of expiration dates. You don’t own or retain any right to the principal underlying equities or instruments being traded. In fact, it would probably be more appropriate to think of these ETFs as a fund dealing in “managed futures” rather than an ETF that attempts to mimic overall index performance. In this way, you should have little or no attachment to these ETFs like you may for a particular company stock you can identify with more readily because you like the product that is being sold on retail store shelves.
Another risk is the outcome of new SEC rules regarding short selling. We have yet to hear the final determination and implications many of the managed ETFs will incur that focus on downside returns by utilizing short selling techniques. Unquestionably, short ETFs have been used as surrogates to increase volume and pressure to the downside. Will they be allowed to exist in current form without increased regulation?
The most realistic scenario for potential risk I can come up with on this trade is a failure of management or forced liquidation of assets that causes the fund to be closed. We don’t really have full transparency on the management’s strategy as they attempt to mimic performance objectives. The same perilous issues of leverage, margin calls, positional limits and counterparty risk may effect liquidity. Like any mutual or hedge fund, the ultimate arbiter of success and failure will be the net result produced by the management team running the show.
Again, ETFs may trade as stocks, but they are still managed funds that have been created out of the same Wall Street brilliance and genius that concocted the now infamous toxic cocktails of mortgage securitization and tranched debt instruments–we all know where that ultimately led in the current housing debacle and credit collapse. Having said all that, utilizing these 3x leveraged ETFs as either a supplemental hedging instrument or outright speculative bet, they present an interesting risk to reward calculation–especially at these price levels where entry points may be deemed attractive.
Strategy and Application of the Trade
To be clear, my initial interest in this trade was strictly as a supplemental hedging instrument against core financial holdings I retain in the portfolio. I don’t want FAZ to increase in value because it means that other positions in the core portfolio are decreasing. So my interest in FAZ is structured as insurance attempting to countermand issuance of risk. Regardless of your reasons to enter this trade, it is essential to remember that there have to be specific limitations in the total amount invested because no matter how interesting it may be, this is speculation at best and it would be unacceptable to push more chips on the table than you are willing to lose.
I’ve written about this previously from my own playbook, but it is worth repeating: Speculative allocations combined should not constitute more than 10-15% of an entire portfolio; of which, individual speculative positions alone should not comprise more than 3-5% of the total portfolio allocation. Any violation of this criteria is risking unnecessary money no matter how good the returns may seem so, please, proceed only if you can afford to lose on any given speculative trade.
To keep it relatively simple, I would initiate a trade on a 1:1 ratio. That is, for example, 100 shares long of FAS against every 100 shares long of FAZ. Whatever your allocation may be in total dollar amount and shares to your portfolio, keeping it simple and well balanced will facilitate the effectiveness of the trade so that you do not exceed a predetermined percentage of your total net holdings.
FAZ is, in effect, a synthetic short position without the risk of actually shorting the underlying position. Because of the crossing in price action of both positions, your capital outlay is almost equal to take both sides of the trade making it very clean and streamlined to initiate.
In options trading, this would be somewhat reminiscent of trading a long “strangle” or “straddle” position by buying volatility. The fundamental difference is that in theory, unlike options facing expiration dates, you are not exposed to timing it to the moment the market makes its move. Not only that, but the options are incredibly overpriced, and for good reason. Usually, price distortions and high premiums invite sellers of options, but no market maker is willing to take on the risk without being ridiculously overcompensated. In this scenario, outright purchases of ETF shares are more cost effective than options.
The real potential outcome and goal is that the multiplier effect should push either side of the trade much higher with returns outpacing the downside losses. Because of these current price levels, your maximum loss on either side of the trade should be capped at approximately eight dollars or less per share if one approached zero, while the inverse correlation on the other side of the trade has unlimited upside. And, throughout their cycle, they have traded at a glaring disparity in terms of price relationship to one another until recently. It would seem that this dislocation of both ETFs trading with relative price parity is unsustainable once the market breaks in either direction. And in this scenario, you can have a non-directional bias on the markets. While I certainly wouldn’t have recommended or applied this trade earlier on much higher price action, maximum gains and limited losses predicated on a binary event is a compelling trade to me.
It’s bizarre, but if you had tried to apply this same strategy upon inception of the newly devised ETFs in the fall of last year, the outcome would have been brutal had you held and you would have taken a major beating on both ends of the trade. Clearly, the ineffectiveness of some of these similarly leveraged and inverse structured ETFs do not perform as promised. In fact, in hindsight, the ultimate trade on some of these newly issued ETFs may have been to short both sides of the trade from the get go. But without the luxury of hindsight, I would never have made that trade anyway.
You could also apply a covered call position by owning the underlying shares and writing the premium, but that would almost defeat the purpose of hedging portfolio risk. The market remains skittish and selling is panic impulsive, not rational and considerate. Of course, it all hinges on your objectives.
In my opinion, financial Armageddon is less likely now and while I can’t say for absolute certain that we won’t have a complete meltdown in the stock market, I think we came damn close and the risk of systemic collapse is finally off the table. However, the risk of pandemics, insurrections and global financial instability will always be out there, no matter what the odds say and no matter how clear the blue skies appear on the horizon. It’s sad and I would love to see a day when these risks no longer exist in the world, but that day has not yet arrived. Until then, the winners and losers in the financial banking sector have been chosen and if you step back you’ll recognize that individual insolvency risk should almost be completely disregarded by observing their dependence on government guarantees that back stop them. In other words, the trade on major institutional “too big to fail” banking stocks going toward zero like Bear Stearns or Lehman Brothers is most likely over; instead, it is now a macro-specific trade betting on the success or failure of the entire economy as a whole.
If you are more bullish by believing the run isn’t over yet in the financials, you could more aggressively adjust your ratio 2:1 to amplify returns on a bullish outcome and actually buy 200 shares of FAS against every 100 shares of FAZ. This would still hedge out the potential loss on the bullish side of the trade because whatever risk that is potentially caused by another panic ensuing sell off in the financials, it will inversely push returns on the synthetically short position by being long FAZ. By having a 3x multiplier, the only thing that may disappoint would be a flatlined market reduction in volatility and that, my friends, is a welcome scenario in any book.
Again, the other trade I have applied previously is specific with FAS, and that is to write naked equity puts which is a neutral to bullish position. I would not advise applying this particular trade at the moment since the financial sector has had quite the run. However, if the market collapses toward a directional retest of March lows, then this trade would be very appealing to me once again.
The thing about buying FAZ is that to do so as a hedging instrument against long positions is probably a worthwhile defensive strategy. However, if you are of extremely bearish sentiment and inclined to believe the markets will return, perhaps, violate the lows in early March then you should not be long the market. In this pessimistic scenario, buying FAZ only is viable as a speculative bet on an entire market collapse which seems ridiculously unlikely, but not an impossible bet in my opinion.
We all know the underlying conditions of the economy and financial system are perilous and wracked with danger going forward. But I think the dichotomy is becoming clear: Professional money managers that missed the move up who are begging for a second chance to buy on a retest, and those that remain short convinced the market has overplayed its hand and will dump on any given notice. I’m an optimist for the most part, so you see where my directional bias remains. However, that does not mean that I take any of the risks for granted to the point that I would trust the market to treat my portfolio with fragile care and consideration.
The old axiom of “sell in May and go away” actually presents an interesting contrarian position to remain relatively neutral to bullish. Tremendous pessimism and too many professional traders attempting to be too cute with timing the market. In this respect, technical indicators can be very misleading because they can be largely driven by the momentum of day traders gaming the system rather than the fundamentals of good companies that produce real earnings poised to survive this debacle not only stronger, but even capturing more market share through acquisition, consolidation or weaker hands folding. Long term shareholders should ultimately do well if they can avoid the risk of destructive leverage and forced liquidation in the short term. Proceed with caution.
Author’s Disclosure: Long FAS and Long FAZ.