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Don't Buy Ultras!

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August 06, 2009 – Comments (11) | RELATED TICKERS: FAS , FAZ

Disclaimer: This is not aimed at those who trade ultras responsibly.

The only sure thing in security analysis, to me, is the ability to determine at this moment whether or not a company is overvalued or undervalued.  A solid strategy, then, would be to go long undervalued companies and short overvalued companies. 

If you're going to buy something like FAZ because you're sure the financials are going to collapse, you're playing a dangerous game.  If you don't get the timing exactly right, you may want to hold longer and longer.  Holding something like FAZ "until you're right" can decimate your portfolio pretty quickly.  A smarter move would be to short FAS if you can find shares, since the decay will at least work in your favor.  However, I still don't recommend that move either in real life.

A good quote I remember is something like this: "the only certainty is in what direction the stock's price will go, not the timeframe in which it'll happen."  With something like FAS or FAZ, if you're wrong about timeframe and correct about the direction, you may go broke before you're correct on your call, if the market decides to stay irrational for a while (which happens all the time). 

My suggestion? If you truly believe the financials are going to collapse, short a basket of financials.  One of the problems with heavily shorting one company is that it's ridiculously risky at times.  This is alleviated by shorting the basket. 

11 Comments – Post Your Own

#1) On August 06, 2009 at 8:11 AM, cmoney85 (< 20) wrote:

boy have I found what you say true in caps, and real life

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#2) On August 06, 2009 at 9:13 AM, toopersent (83.25) wrote:

great advice, thanks!  +1

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#3) On August 06, 2009 at 11:30 AM, kaskoosek (37.62) wrote:

Can someone explain to me why financials are going to collapse, because I for sure know they are being bailed out through cheap capital from the Fed.

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#4) On August 06, 2009 at 11:56 AM, TMFBabo (100.00) wrote:

kaskoosek: The financials were just used as an example.  FAZ is a very commonly traded ticker, so I figured it would hit home for more people.  I am not short the financials. 

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#5) On August 06, 2009 at 12:03 PM, WeenTang (37.69) wrote:

I've read a lot of negative posts about Ultra/Levered ETF's, and I'm not sure I fully understand the risks.  The posts I've read basically say they are "too risky" or "if you get the timing wrong, you'll get wiped out" but provide little detail beyond that.

It seems to me that if you are going to buy a 3X levered ETF, you should expect 3X the risk.  All equity trades are risky, and these triple the risks.  So yes, you should be prepared to handle extreme volatility.  Beyond the volatility, are there other risks that don't occur with standard equities?  I am not at all an ETF expert, so I'd be very interested to hear what other risks exist for these instruments.

Also, I don't like when people call things "too risky."  That assumes you know someone elses risk tolerance.  CAPS member span the entire spectrum of risk tolerance.

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#6) On August 06, 2009 at 12:16 PM, portefeuille (99.66) wrote:

#5 You may want to have a look at these posts.

Any sense holding on to FAZ at $28?? (have a look at the stuff linked to comment #22!)

2/3/4.../n X Leveraged Strategy : Weapons of Wealth Destruction or Creation - Attempt at DIY Primer

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#7) On August 06, 2009 at 2:07 PM, BigFatBEAR (29.29) wrote:

"the only certainty is in what direction the stock's price will go, not the timeframe in which it'll happen."

Even the direction of a stock is not at all certain! We only think it is.

But yes, the market is very unpredictable and moves in an incredibly-fast slow-mo, neither of which are amenable to playing ultras.

If you're bearish on financials, I'd either research them a ton and short a few companies, or simply buy puts on something like XLF. With the puts, you at least know in advance that you're not going to get covered into an insane rally, and you also know in advance the max that you can lose.

Just my 2 cents. :)

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#8) On August 06, 2009 at 4:50 PM, SkepticalOx (99.53) wrote:

#7

You can apply the same logic to Triple-leveraged ETF's too. Same as a put option, 3X Reverse-ETF like FAZ gives you leverage, the same as an option, and you know, the same as a long put option, that your maximum loss will be the initial investment.

Shorting a stock or even a basket of stocks exposes you to infinite loss (past your initial investment).

The time-decay is a huge issue with the 3X ETF's (it's always headed towards zero), but for day-trading or even short-term market movements, it could be a useful too... FAS (3X bullish financials) increased 5X from the low in March into May/June ($2 to $10, and this was before the reverse-split). 

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#9) On August 07, 2009 at 1:33 AM, ChrisGraley (29.81) wrote:

Actually the closest thing you can get to a free lunch in the market is to buy deep in the money LEAP puts on a pair of leveraged ETF's like FAS/FAZ.

It works great when each member of the pair has close to the same NAV. (like when they first open or when they cross)

The Leap gives you a lot of time for decay on both sides. The only reason that you buy them "deep in the money" is that you get some protection if you have to sell them unexpectedly in the short term when one of the funds has risen in value.

In the long term, it's better for your peace of mind if you sell both at the same time, but if you're really trying to maximize the gain,  you could try to sell each one at a low in a volatile market.

One thing to watch out for is a reverse split with these funds.

It's not a huge deal, in that on paper you don't really lose anything in the reverse split, but it does leave you with an orphan LEAP that doesn't get as much attention in the market. It also gives investors a false sense that the decay has dissapeared for a while. It hasn't.

btw, if you would have tried this on 11-10-2008 for the FAZ/FAS pair FAZ was opened at $648 and FAS opened for like $249.

That would have made you almost $80,000 (minus whatever the option prices were at that time and the commision) for every option that you bought if you sold those options today.

 

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#10) On August 07, 2009 at 1:36 AM, ChrisGraley (29.81) wrote:

That would have made you almost $80,000 (minus whatever the option prices were at that time and the commision) for every option that you bought if you sold those options today.

that should have been written "for every option pair that you bought"

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#11) On August 07, 2009 at 7:03 AM, TMFBabo (100.00) wrote:

Shorting a stock or even a basket of stocks exposes you to infinite loss (past your initial investment).

Very true.  I realized not long after posting that buying a 1x inverse financial ETF (don't have the ticker on hand) is about the same as shorting a basket and only exposes you to 100% potential loss.

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