Leveraged ETF Arbitrage (LETFA) w/ Real Money
First off I want to say that I'm a complete amateur and I have no idea if any of this stuff I am saying is actually valid or just totally wrong. I know this is risky for sure so be careful.
Some people have floated around the idea of shorting a pair of opposite ETFs. The idea is to offset their moves due to the direction of the market and profit from the volatility decay. (I'm going to call this trade LETFA, which stands for "Leveraged ETF Arbitrage", maybe it will catch on haha). This seemed to me like an interesting strategy but I haven't actually seen anyone implement it with real money. So I figured why not try it myself. At worst, I might lose some money but I would be doing the CAPS community a service :)
So yesterday, I shorted about $1500 of each FAS and FAZ. In order to control risk, I plan to hold until the ratio of FAS/FAZ is over 2 or less than 0.5, at which point I will rebalance them to have the same value again (let's call this the "rebalance limit ratio"). This way, the maximum amount I could lose on any given day won't be catastrophic and cause a margin call. In what I consider the worst case scenario, I will be shorting twice the amount of FAZ as FAS, and the market will plunge 33%. Here I will lose 33% of however much I am shorting (for example, if I am shorting $3000 total, $2000 of FAZ will go to $4000 and $1000 of FAS will go to $0, so I would lose $1000). Anyways, if you want to follow the portfolio, you can see it here. One hypothetical portfolio using these rules can be seen here.
It's common knowledge that leveraged ETFs like FAS and FAZ are terrible long-term holdings (though surprisingly, there are still many of uninformed users). Accounts like UltraSuck have racked up points by simply redthumbing these ETFs and nothing else. This strategy clearly has a lot of potential for profit, as you can see if you pull up the charts of FAS and FAZ - they are down 82% and 92% respectively since their inception about six months ago.
The reason everyone hasn't already jumped on this opportunity is because of the risks involved. This is because the two opposite ETFs don't fully offset each other after the first day, because when the position sizes change, one ETF will have more weight than the other, making the trade no longer market-neutral. Simply letting your positions run w/o rebalancing them will most likely make a lot of money in the long run, but you will be down a lot during prolonged rallies and corrections. The risk is that you will face a margin call and never get to the long-run.
I believe it is possible to largely mitigate that risk simply by rebalancing your portfolio whenever the proportions get out of whack. How often depends on your desired risk/reward level. This will mean you can miss the best days (when you have a large short position in FAS and the market plunges, for example), but it will also keep you out of the worst days (large short position in FAS and the market rallies). But you have to keep transaction costs in mind. So depending on your bankroll, the risk-to-return sweet spot changes.
I wrote a computer program to backtest different variations of this strategy. I plugged in the past price changes for FAZ and FAS and let the program run thousands of random sequences of these price changes. I played around with the starting funds and the ceiling and floor for possible FAZ and FAS prices.
I found that if you start out with $3000, the optimal rebalance limit ratio is around 1.7 to 2.1. The higher the starting funds, the lower the optimal limit ratio becomes. Very interestingly, if you start out with about $10,000 or more, you can actually just rebalance every few days if the prices change significantly, and make a decent profit with relatively low risk. I wonder if there are any hedge funds using this strategy! Surprisingly, you can actually rebalance every single day and make money, because on average, the funds have a negative tracking error, though this would not take advantage of the 3x daily returns math behind the strategy.
The problem with backtesting is that the results depend on the past market behavior, which can change in the future. The past few months have been very volatile, which is good for this strategy. So if volatility decreases, which has been happening recently, the optimal limit ratio actually goes up and the strategy becomes less profitable.
Has anyone else done some research into this strategy? And hopefully I didn't do something totally wrong or make a huge logical error. Let me know if you see something weird before my stupidity costs me a lot of money :)