Financial ETFs: Shorting FAS, FAZ at the Same Time

Includes: FAS, FAZ
by: David Oldenburg

Are all ETFs designed to lose money over time? Is this just the price we pay for wanting to be diversified - or even leveraged - in a particular sector?

If we take a close look at ETFs over the 2010 year, we see a big problem for long-term investors who feel compelled to invest in many of the popular ETFs. I have talked about this issue many times on my radio and internet broadcasts. Today I will look at FAS and FAZ, their 2010 performance and what some traders call the "Holy Grail" - shorting both stocks at the same time.

If we want to invest in the financial markets, we might buy the FAS (Direxion Daily Financial Bull 3x shares). The FAS invests in approximately 85% stocks according to Yahoo Finance. The idea here is that if the financial stocks go higher, we will make 3x as much money...right? FAS began 2010 around $28 per share and ended 2010 at around $28 per share, so the gain is a big fat 0%, while the XLF (Financial Select Sector SPDR), was up around 10% for the year. Shouldn't we see FAS up 3x or near 30% for the year? We know 2010 was a great year for stocks, but if you had held FAS, you would have been left with a zero return.

What about the FAZ (Direxion Daily Financial Bear 3x shares)? FAZ is designed to be the short version of the FAS. In other words, if FAS ended the year with a zero return, we should see the same return for FAZ. In fact, we see that FAZ began 2010 around $17 per share and ended the year around $9.50. This is a near 50% haircut in value.

Many investors have talked in previous blogs and articles about the ultimate profit center, shorting both the FAZ and FAS and making big returns. I did just this last year and it actually worked. I am no longer in the trade. Why did I get out of such a great trade? The problem with shorting stocks that are leveraged 3x is the risk of a big turn in the market to the upside or downside.

Let's take current 2011 prices on the FAZ and FAS. The FAS is around $30 per share and the FAZ is around $9. If we short the FAS and FAZ at the same time, theory says that if the FAS goes up by 10%, the FAZ will drop by 10% and vice-versa. So, let's say the market takes off and the FAS jumps 10% each day over the next 3 days. Remember, it is 3x leveraged so this could easily happen in a breakout market. We should be equally protected because each moves 10% each day in opposite direction? This is where the novice trader needs to listen up.

If the FAS jumps 10% each day for 3 days, it will be trading near $40 per share or up about $10 per share. If the FAZ drops 10% each day for 3 days, it will be trading near $6.50 per share. Ouch! If you had shorted both stocks, you would have one stock with a loss of $10 per share and one with a gain of just $2.50. Here is the real problem: The FAS could take off and go to $100 per share and you would lose $70 per share in a short, however, the FAZ is a $9 stock and can only go to zero. For this reason, shorting both of these stocks, while profitable over a long period of time, could produce steep losses if the market moved quickly in any one direction. Again, I did this trade for part of 2010 and made about 5% but then got out of the trade for fear of the unknown.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.