The Most Consistent Risk/Reward Speculation That I Have Ever Found

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Includes: DUST, EDC, EDZ, JDST, JNUG, NUGT, SVXY, TNA, TZA, UVXY
by: Scott Brown

Summary

The best speculations are ones where the odds are firmly stacked in your favor.

Leveraged funds can be great gambles but are typically very poor long-term investments.

Shorting pairs of leveraged funds in volatile sectors can create a roughly market neutral speculation that has a history of outperformance.

Everyone loves a good speculation. The problem is that every good speculation has a good bit of risk associated with it, thus the reason why it is considered speculation and not an investment. I've heard all sorts of market "experts" that have revealed the magic secrets of how to speculate properly by day trading or using options to manage and control risk. Some are obviously more successful than others, but in general, I've never found any one of these strategies to be consistently profitable year in and year out.

I've always had a fascination with numbers and risk and I've always thought that there are certain risks that are worth taking simply because the numbers and the strategy back up the risk. Many professional gamblers have figured this out. It's not that they are better at luck than others, they just understand the odds and how to play them better than others.

Investing has gotten more and more difficult as the Fed has effectively manipulated the entire system from the top down. No longer do we have to just look at the fundamentals of a company, but we now also have to guess what Fed policy will be in the future because that will affect our analysis of fundamentals. Everything has turned into a best guess scenario and nothing seems certain.

What seems to be certain is volatility. Markets always go up and down - some markets much more so than others. Certain trading products that have been invented to help investors take advantage of that volatility may have succeeded in doing so in ways that the sponsors did not intend. But if you understand the numbers - the odds - you can make a good speculation that nearly always works over time. Test out my theory and run the numbers for yourself. It's not perfect, but it's about as close as perfect comes in a speculation. And the beauty of it is that it is roughly market neutral. It doesn't matter if the market goes up or down - only that the market does indeed move around.

I was having a conversation with a friend of mine who likes to dabble in investments and he was asking me back in the first week of October for some tips on where to put some money to work. I mentioned to him the strategy I'm writing about today and suggested he try it out. For grins and giggles, I ran the numbers today to see how the strategy would have played out. After I ran those numbers, I did the same for three other randomly picked investments from the same fund sponsor. As you will see when you read on, every single one of these speculations was profitable YTD (January 1, 2014 - December 17, 2014 per data gathered from Yahoo Finance). When I originally stumbled upon this idea back in 2008-2009, I ran the numbers on other funds and received similar results.

The strategy is simple enough. When you don't know which way the market is headed, you play both sides of it. If you want to make it more fun, you leverage both sides of it. Direxion funds pioneered the 3X leveraged funds several years ago and then options makers made the speculation even more interesting by adding option leverage to the already super volatile 3X funds. While a day trader can get lucky with highly leveraged funds, most long investors just end up losing money. What happens is that in a volatile market when a fund increases 20% many investors do not sell the fund, and then when it gives back the gains it just made and decreases 20%, investors expect that they should be back to zero. In actuality, though, it doesn't work that way. $100 + 20% = $120. $120 - 20% = $96. Add to that the expense ratios of the funds and it's highly likely that there will be NAV erosion over time. When I realized that, I started thinking, "Well, what if we just shorted the shares of both the long and short side of a trade?" That makes the trade roughly market neutral and profit dependent not upon performance, but upon NAV erosion over time. Here's the data from when I recommended to my friend that he short both the Direxion Daily Gold Miners Bull 3x Shares ETF (NYSEARCA:NUGT) and the Direxion Daily Gold Miners Bear 3x Shares ETF (NYSEARCA:DUST) in the first week of October:

In the above example, I started with roughly $57,250 invested, split equally between short shares of both DUST and NUGT. I left the number of shares constant and I am assuming that there is sufficient cash in the account to fully cover the trades. In other words, this table does not include potential margin interest costs. Notice that even though there was a loss of $4880 on the short DUST position, there was a corresponding gain of $15,879 on the short NUGT position for a net gain of $10,999 in 75 days…19.2%. Not bad.

I decided to randomly pick markets that I thought would be volatile and then extend the trade time frames to see how the strategy would play out over the course of a year. I chose junior miners (always a fun and volatile ride), emerging markets, and small caps. Here's how they played out:

Small Caps: the Direxion Russell 2000 Bullish 3X ETF (NYSEARCA:TNA) and the Direxion Russell 2000 Bearish 3X ETF (NYSEARCA:TZA)

Here I started with $113,052 split equally between a short position in TNA and TZA. As with my other project, the number of shares shorted stays constant in both. For the sake of space, I have only listed monthly results. In this instance, one can see that NAV erosion led to a combined portfolio gain of $14,523 or 12.8% in the course of a year. Again, not too shabby.

Next, I decided to hit up the never disappointing emerging markets. Those are always good for some volatility, right? Here's what happened with the Direxion Emerging Markets Bull 3X Shares ETF (NYSEARCA:EDC) and the Direxion Emerging Markets Bear 3X Shares ETF (NYSEARCA:EDZ):

Here I started with an investment of $101,084 split equally between shorted shares of EDC and EDZ. As with the other charts, the number of shares remained constant the whole time. The end result was a combined net gain of $11,673 or 11.5% for a year's time due again primarily to NAV erosion. This is starting to get fun. I saved my last experiment for one that I knew was going to be chock full of volatility - the junior miners. I picked and chose a little bit of the data that I displayed on this one just to demonstrate how even in a relatively market neutral speculation, the volatility can at times cause a person's stomach to really churn. However, the more the volatility, the more fun the end results can be. Here's what happened with the Direxion Daily Junior Gold Miners Index Bull 3X Shares ETF (NYSEARCA:JNUG) and the Direxion Daily Junior Gold Miners Index Bear 3X Shares ETF (NYSEARCA:JDST):

You can see that I started with $99,952 split equally between JNUG and JDST. Within a month of opening the position, the combined short was down more than 25%. Ouch! That is because of the compounding feature of these leveraged funds. When the market is moving strongly in one direction, the funds will compound more heavily on that side than they will on the other side of the market. If there is one main risk to this strategy, this would be it. If your market ONLY moves one way, you lose. That is when you are better off with a long combination, rather than a short one. Hey, that's why it's a speculation. If the short strategy ALWAYS worked, everyone would be doing it. Anyway, check out how the short strategy ended the year. The NAV erosion affected BOTH SIDES of the market significantly. While the short JNUG position returned nearly 90%, the short JDST position returned nearly 50%. COMBINED, THE STRATEGY RETURNED NEARLY 70%! Fun times for sure.

Some risks to be aware of include availability of shares. These shares are not always easily available for borrowing due primarily to their status as short-term trading vehicles. Sometimes if they are available, your broker might try to charge you an added fee to short them. Make sure you check availability before you try to execute the trade. Second, be aware of the possibility that your shares could be called back if they are in short supply. That might force a trade to be closed prior to when you want to close it. Lastly, as mentioned above, this works best in a volatile market. If the market is only down or only up, it won't work (it would work in that scenario by being long both sides of the market). I would encourage anyone who is interested in trying the strategy to pull data from numerous time points and see how it worked in the past on other volatile leveraged funds. Many of these funds now have a several year history, so longer-term data is now widely available and easily exported and manipulated from sites like Yahoo Finance. I presume (without running the numbers) that it would be especially profitable on VIX pairs like the ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY) and the ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY) if anyone could find shares to borrow.

All sorts of fun things can be added to this by using various option strategies but I will leave that for another article or perhaps some other writer who can share their experience. I'm interested in your comments below.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not intended as and should not be construed as individual investment advice.

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