Avoid Options on Inverse Index ETFs

Includes: DIA, DXD, QID, QQQ, SDS, SPY
by: Condor Options

Reader S. V. raises an interesting question:

I am working on scenarios to trade the contra-ultra indexes like SDS to take advantage of either a combo spread (selling puts and buying call) or another method to take advantage of price movements while reducing risk.   Any thoughts?

Interesting idea.  These Ultrashort ETFs have really gained in popularity and most of them (like the UltraShort S&P 500 (NYSEARCA:SDS), Dow30 (NYSEARCA:DXD), QQQQ (NYSEARCA:QID)) now have enough volume to make them decent trading vehicles.  The actual stock, that is.  

The options are another story.

  1.  A big difference here is the lack of volume.  In the case of SDS, the open interest in the July ATM puts is listed in the hundreds - not thousands - of contracts, versus open interest of 18,000 in the SPY ATM calls.  Where this really makes a difference, though, is on the side that anticipates a market sellof (SPY puts; SDS calls).  SPY puts usually have higher open interest, so it stands to reason that on an inverse index, you’ll have a lot more liquidity on the call side (since people typically only think of the inverse products for hedging purposes, whereas it’s natural to turn to a normal index for both long and short purposes).  In the SDS Julys, the call open interest is still only in the 2000-3000 range, which isn’t untradable, but isn’t compelling, either.
  2. The spreads on these options are also a bit wider in the inverse products. Why hassle with 0.15 or 0.20 spreads on these inverses when you can trade the index ETF options and thereby bask in the unrelenting glory that is penny pricing?  One of the lowest circles of market maker hell would have to be an open outcry SPY pit.
  3. The inverse products don’t always behave as you might expect.  Adam over at the Daily Options Report did a whole series of good posts on this topic, and the gist is that because these products are designed to track the performance of their index on a daily basis, they’re not going to move in tandem over time.  So if you want to be short technology, buying QID isn’t necessarily going to give you the same outcome as if you just shorted QQQQ.
  4. Which bring us to the biggest reason to avoid trading inverse product options: it’s a totally superfluous approach.  We’re kind of burying the lede here, but you can construct the same position with ordinary index ETFs options that you can using the inverse ETFs, and with none of the disadvantages that we’ve outlined above.

Let’s take S. V.’s example. Say you’re long some stock in SPY as a core portfolio position, and you want to protect your downside. Collaring your stock is a great way to do that, because each 1-lot position gets you short 100 deltas and carries almost no gamma, so the hedge is easy to size and you don’t have to worry about your hedge losing its potency if the underlying makes a dramatic move. S.V. wants to put on a combo spread in SDS options, which entails selling puts and buying calls with the same strike prices in a 1:1 ratio. No matter which strikes you use, that would get you long 100 deltas, which (since this is an inverse of SPY), is like being short 100 SPY deltas.

You can build the same position by selling calls and buying puts (again, with the same strikes, same month, on a 1:1 ratio) in SPY. The liquidity should be better (making the hedge a touch cheaper), and the value of the position should move in direct inverse correlation to the movement of SPY. The only reasons we can think of why someone might want to use options on an inverse product instead would be 1) to take advantage of the leverage built into the UltraShort ETFs, or 2) to construct a fancy arb of the disparate movement between the inverse product and its index. But (2) is difficult and expensive, and not what S.V. was asking about. And (1) doesn’t hold water here, since options are already leveraged, and it’s a lot easier to just use a few more options contracts than to risk underperformance or mismanagement in a leveraged fund.