walt373 (99.83)

Leveraged ETFs Arbitrage (LETFA) Follow-Up

January 28, 2010 – Comments (6) | RELATED TICKERS: FAS , FAZ

Hi everyone, this is a follow-up to my blog post back in May of last year, when I started the strategy of shorting leveraged ETFs to take advantage of their decay.

So far the strategy has been profitable, though not as profitable as it would've been in 2008 and early 2009, due to the market's strong upward trend and reduced volatility.

Results

Profit: $379.44 (including transaction costs of $7 per trade)

Tax loss: $1027.75

Tax gain: $0

Total short position sizes: varies between $2200 - $6000

Transactions

FAS    Sell Short        May 15, 2009    31.00    46.655    1,439.30
FAZ    Sell Short        May 15, 2009    26.00    55.90    1,446.40
FAZ    Sell Short        Aug 3, 2009    30.00    32.53    968.90
FAS    Buy to Cover    Sep 16, 2009    16.00    82.87    (1,332.92)
FAS    Sell Short        Nov 30, 2009    26.00    74.33    1,925.58
FAZ    Sell Short        Nov 30, 2009    95.00    19.91    1,884.45
FAS    Buy to Cover    Jan 7, 2010    11.00    85.58    (948.38)
EDC    Sell Short        Jan 22, 2010    6.00    120.26    714.56

Explaining the transactions... the first two were when I started. The next two transactions were for rebalancing the positions. The November transactions were when I decided to put more money in this strategy. Rebalanced again on Jan 7th.

The most recent transaction where I shorted EDC bears some explaining - normally I would've shorted FAS, but I had recently covered FAS for a tax loss, and did not want to re-short it and have a wash sale (cancelling the tax loss). So I shorted the 3x Emerging Markets ETF, EDC, instead. I realize these two ETFs don't always move together, but I thought they would be close enough to hold me over until I could re-short FAS 16 days later. I actually got lucky because EDC dropped more than FAS, and this boosted my return by about $40 (so I cheated a little). More on tax losses later.

Some Thoughts

- The secret is to rebalance the positions periodically, when one size gets too large compared to the other. This reduces risk and ensures you are not inadverdantly betting on market direction. But rebalancing too often will cut into your profits, so you need to find the sweet spot based on your short size. The more capital you have, the more often you should rebalance, since the cost of each transaction becomes a smaller percentage of your capital.

- The beauty of this strategy is that it requires no upfront capital since you are shorting only, and unlike traditional shorts, you don't need a large "buffer" because the strategy is surprisingly very un-volatile. Most of the time, when the positions are roughly balanced, you will hardly make or lose any money on any given day. I was lucky in that this strategy never had a down period, but I would be very surprised if you consistently lost enough money so that you needed more cash for collateral. I would say 10% of your short size is enough.

- Another pleasant surprise was the tax loss you can harvest using this strategy. You can make a profit on the overall strategy but get a tax loss by only covering the shares that went up. Even if you have profits on both sides, tax rules allow you to choose the most expensive lot, so you can choose to cover the most recent lot you shorted, which you probably have a loss on. Also, instead of covering, you can short more of the other side, so there is room for maneuvering. To be honest, I don't know much about taxes, so I am not 100% positive if this is how it works. Someone let me know if what I said is correct!

- One drawback of the strategy is that now I am having trouble shorting FAZ. For the past couple of weeks, my brokerage, Scottrade, has not had shares of FAZ available for shorting. In fact, I have not been able to get shares of any 3x bear ETF. They still have the bull ETFs, though. I am thinking about moving into 2x ETFs.