A risk-free trade shorting leveraged ETFs

Leveraged ETFs, or trader crack, are the causative agents of panic attacks, late night vomiting, and brief moments of sheer ecstasy. Use of these products will often lead to marked declines in account value and frequent head-to-keyboard motions followed by obscenities. Leveraged ETFs undergo decay over time and volatility meaning that eventually the value of any leveraged ETF will, with high probability, approach zero. I won’t bother to write what others have explained well elsewhere but I will outline a trading strategy that utilizes this value decay to profit without risk.

First, take a look at a few charts of 3X ETFs, both the long and the inverse shown paired up for relative performance:

FINANCIAL 3X ETF PAIR
chart here

SMALL CAP 3X ETF PAIR
chart here

ENERGY 3X ETF PAIR
chart here

What you will note is that the gains in both the long ETF and its inverse ETF do not cancel each other out as they should if you were short and long the same stock. This is the effect of the decay.

By using a hedged position of being short (in equal $ amounts) both long and inverse ETFs (ie short the same dollar amount of FAS and FAZ), the position will profit from the net return (decay). You will see that over a volatile 3 month period average gains would be around 10-30%. Not a bad return on an annualized basis. The trouble will be finding shares to short. The big boys knew about this strategy a long time ago.

20 responses to “A risk-free trade shorting leveraged ETFs

  1. Hi there –

    I hope you don’t mind but I have included your first paragraph “Leveraged ETFs, or trader crack, are…” as a quote on my blog: http://trader6.wordpress.com/add-or-update-your-own-quote/hedge-funds/

    I enjoy your writing style and would like to give you credit but I don’t know your name.

  2. Hi there Stuart. I don’t mind at all. Your blog is a great resource for traders.

    Mike Roberts

  3. Hi Mike – I would like to harvest a few more great quotes from your blog and post them along with your profile on my blog. If you check out http://trader6.wordpress.com/2009/01/21/matt-blackman/ you can see what I would like to do. Also a small photo would be great. BTW, Matt was very impressed with your risk-free leveraged ETF strategy and would like to interview you. You interested?

  4. Pingback: Funds « TRADER6 Blog

  5. Mike -

    I got interested in your (an a few others out there on the web’s) theory and spent several hours trying to model every possible scenario shorting paired 3x ETFs. I created a spreadsheet that generates random returns over a 60+ trading day period. Although it shows a net positive most of the time, there are ways to lose doing this. Email me and I’ll shoot you the Excel file – maybe you can verify or show me my error. I was hopeful and wanted to prove it to myself before executing. I still believe shorting any of them at spike high extremes is a winner.

  6. it’s not risk-free–in fact, there is an infinite risk of loss. basically, you are betting on volatility. it’s a good bet right now, but if the market trends upwards OR downwards without volatility the “decay” becomes negative and you’ll lose money. the worst case scenario is that the market will trend upwards infinitely. you would double up on your bearish short (buy to cover at 0) but you wouldn’t be able to cover your bullish short at all.

  7. just to clarify–i meant risk of infinite loss

    and an example of losing money in this scenario:
    day one, index = 100
    bullish x2 etf = 100
    bearish x2 etf = 100
    you short them for $200 cash

    day two, index = 110
    bullish x2 etf = 120
    bearish x2 etf = 80
    you’re breaking even

    day three, index = 121
    bullish x2 etf = 144
    bearish x2 etf = 64
    you’d cover at 208, putting you at -8 for the entire trade

    the exact same thing happens if the index goes down 10% both days, so you’re really betting that the market won’t go anywhere

  8. Yes. In theory, infinite losses are always possible shorting.

    However, over the past 3 months XLF, the financial index, has been basically one sided – down 20%. And both FAZ and FAS are down 60%.

    http://tinyurl.com/b2qdnh

  9. This is very interesting. I had thought about this strategy before. Your blog motivated me to run a few spreadsheets on different ETFs. This strategy will work as long as the move in the underlying is not directional up or down. An example of it not working would be the HND.TO AND HNU.TO pair. If there is a strong one sided directional move this strategy will not work. Need volatility to get outsized returns

  10. And I think it may work better for 3X vs. 2X ETFs

  11. I think this strategy is very powerful if you have a reasonably high chance that a stock is going to trend in a particular direction eventually. I think the FAZ (short 3X financial sector) is an excellent example. Simply short the stock and hold it. I modeled some spreadsheets and if there’s a second financial crisis (stress test results cause panic), you may have to suffer something like a 90% drawdown. But you don’t have a loss until you liquidate your position. As the economy recovers, which it will eventually do, FAZ will become a penny stock and you’ll have a huge gain if you remained in a short position.

  12. How about hedging the risk of a directional move of the levered ETFs with option strategy?

  13. In essence by shorting both you are entering a short straddle, short theta, and purchasing positive gamma. I analyzed this by some Monte Carlo simulations and theoretical decay modeling. I can provide more details if needed.

  14. PS Essentially this is a Martingale system; you are guaranteed profits, so long as you can risk infinite drawdowns, AND there is no long term trend. Read about that and the St. Petersburg lottery.

  15. I was under the impression that Martingale offers no statistical advantage over long term.

    http://en.wikipedia.org/wiki/Martingale_%28betting_system%29

  16. Having attempted it myself, i can say that there are a lot of complications with this strategy.
    One thing that is very important is BUY CALLS at a strike that is comfortable to you (or buy puts instead of shorting the stock directly).
    If you shorted FAS and FAZ when they were both in the $40s in july, you could be in margin call trouble when FAS went up to $90 while FAZ dropped to $20.
    That is why it is very important to “build a ceiling” on both the bull and bear sides

    Another concern is that the long etf (FAS) will be called away from you when dividend time comes, so if you have losses on it, then you risk losing the tax break if you re-short it immediately after the dividend is assigned.

  17. Thought about this a while ago and the divide between theory and practice could be substantial. For example, Interactive Brokers charged a Hard To Borrow Fee when trying to short FAZ and FAS:

    http://www.wheredoesallmymoneygo.com/hard-to-borrow-fees/

    The fee at the time I checked was 20%+. I’m sure it goes down with volatility, but so does the expected return from the strategy since its alpha come from volatility.

  18. Do you want returns of 100%, 200%, 300% and MORE!!! I have THE SYSTEM. Call me today and I will let you in on THE SYSTEM for a small fee. Call me at 416-684-9847

  19. LOL. Great advice. If someone had tried this “risk-free” strategy just a couple month after your suggestion, they would have lost a cool 500%. Sounds pretty risk free right? What other risk free trade ideas you got for us?

  20. Superb, what a weblog it is! This website presents useful information to us, keep it up.

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