Use access key #2 to skip to page content.

arboretum (28.70)

The short, ugly daemons

Recs

17

March 27, 2009 – Comments (14) | RELATED TICKERS: SDS , SSO , SH

I have made a couple of comments lately about the dangers of both short and ultra ETFs and short sales. I am putting them here, in depth, for future reference since I keep seeing this come up.

If you want to make money from falls in the price of an index, sector or stock, you have three choices - put options, short ETFs or short sales.

Put options

A put option is an option to sell a stock at a particular price. You pay for the privellege of selling the stock at a fixed price at some point in the future. Usually this price (the strike price) is about what the stock price is when you buy the option (called an at-the-money option). Put options are VERY risky and will mostly lose all their value over a short period, so in most ways they are by far the most risky of these choices. However, it is hard to get approved for options trading because brokers know this. Also, although options are hugely risky they also provide a way to hedge a long portfolio with a very small percentage of capital, and if only 1% of your capital is in well-chosed option hedges this is not such a risky strategy.

Short ETFs

There's been much talk lately about the "ultra" and "ultrashort" ETFs, which are funds designed to mirror an index and move by a multiple of how that index moves. This sounds great - if you buy SPY, it will mirror the movement of the S&P. If you buy SSO, it will move by 2x the S&P. Similarly, SDS will move 2x in the opposite direction to the S&P. So, if you are a naive buy and holder and think the market has bottomed, you will maybe think about buying SSO instead of SPY. Or if you think it will be a bit lower in 2010 than now you might buy SDS. This is a BAD IDEA.

Since CAPS scores depend on movement relative to the S&P and the ultras are designed to move more than the index, ultras are often seen in all-star portfolios since they are an easy way to get points in CAPS. This does not mean they are a good investment in real life. The leverage (multiplied movement) of these ETFs is accomplished using stock options. Like options, Ultra ETFs are hard to trade because they have huge swings which are influenced by volatility as well as price, they suffer time / volatility decay and there are other serious problems. So over time, the value of your ultra will drop even if the index keeps moving slowly in the right direction. If the index is flat you will lose money for sure.

In addition there are tax complications to the ultras. I held SDS over the year end last year with disastrous tax consequences - DO NOT DO this with any ultra ETF. If the ETF is up on the year, it will make a capital gains distribution and you will lose this from the value of the ETF. You don't lose money then, but you lose big at tax time, because you can't deduct your stock losses from the money you gained on the capital gains distribution.

Short sales

A short sale is when you borrow a stock from a broker, intending to buy the stock back at a lower price and thus repay your debt. New traders should also be aware that short sales carry a lot of risk. In particular, the potential monetary loss with a short sale is INFINITE (because there is no limit to how high a stock can go and thus how much money you will need to buy it back). This is much less of an issue with SPY than with say a beaten-down financial stock, but still worth bearing in mind. With an ETF, even an ultra ETF, you maximum loss is limited to the value of the ETF you purchased because it can only go to zero and not below.

The second issue is that clearly your broker will not let you take an infinite loss, because they too would go bankrupt. So once your loss on a short sale gets close to the total value of your assets, your broker will make a margin call. The margin call will force you to cover your short, potentially losing you not only the value of the short sale but much of the rest of your brokerage account where you will be forced to sell stock at whatever the market price is.

Thirdly, if you short a lot of a stock that is in short supply, the person you borrowed it from might want it back, and you can thus get forced to sell when you don't want to.

Short sales require a margin account, which a lot of beginning traders don't have. You might think this is a good thing, but it tends to lead them down the primrose path of ultra ETFs which have no requirement for margin or options trading. The presence of short ETFs in many CAPS all star portfolios only exacerbates this.

My suggestion is, if you are beginning trading, don't have a margin account, and you really really want to short and not just keep long-only positions, use only NON-LEVERAGED short ETFs. For example, SH is a fairly safe way to gain from a drop in price of the S&P, or to hedge against a sudden crash if you are afraid such a thing is close.

Hope this helps somebody!

14 Comments – Post Your Own

#1) On March 27, 2009 at 12:14 PM, kdakota630 (29.81) wrote:

In addition there are tax complications to the ultras.

Great blog!  Most people (including myself) probably haven't considered the tax consequences.

However, in my case that's not an issue.  All my money is either in a LIRA, or a TFSA (tax-free savings account), where as long as my yearly contribution is $5,000 or less, I don't pay any tax on capital gains.

Report this comment
#2) On March 27, 2009 at 12:23 PM, arboretum (28.70) wrote:

Good point kdakota630

If you are not in a taxable account, the tax issue with ultras does not apply. And thanks for the thumbs up!

By the way I am aware that the past tense of "choose" is "chosen" not "chosed". Wish there was a way to edit blogs for typos.

Report this comment
#3) On March 27, 2009 at 12:41 PM, binve (< 20) wrote:

arboretum, Great post! Lots of great information and well thought out. Thanks! And talking about the tax issues is really good, since taxes are on everyones mind right now :)

Report this comment
#4) On March 27, 2009 at 1:42 PM, GVdrone (< 20) wrote:

Hey arboretum, is there a ascemding flag in fanancials right now?

 

http://www.marketoracle.co.uk/index.php?name=News&file=article&sid=9701

Report this comment
#5) On March 27, 2009 at 2:06 PM, IIcx (< 20) wrote:

Great article kdakota630

Like may I have fallen in the trap of buying ETFs and have to say I'm surprised by all the media hype and the false statements made about what they actually are in their stock descriptions.

I'm in the process of dumping them in favor of better investments.

Thanks Again, IIcx 

Report this comment
#6) On March 28, 2009 at 10:39 AM, arboretum (28.70) wrote:

GVdrone

I guess you're making a point for me. Looking for technical signals in sectors like financials and betting on them with ETFs like FAS and FAZ is basically a legal form of gambling. As with Las Vegas, the house will take it's cut, win or lose.

IIcx

Yes, I've been there too. And I do still use them as a short-term hedge occasionally, but they are definitely not advertised in a way that reflects their risk.

Report this comment
#7) On March 28, 2009 at 4:04 PM, kstarich (30.62) wrote:

Great blog.

My question- What is the year ind date?  Is it Dec.31 or another date.

I would love to see more blogs like this.

Report this comment
#8) On March 28, 2009 at 4:23 PM, belfairinvestor (29.45) wrote:

Ultra ETF's are great in Caps if you can catch them in the right direction. I've been lucky enough to raise my score from -3000 to where it is today.My player rating was once .01 and only 10 players with a rating lower than mine. That almost hurt my confidence!

In real life I only use a very small amount of my risk capital. When I trade this way, I am mentally at the roulette wheel of my local Indian Casino, keeping in mind that I may lose this money at some point.

Thank you for the heads-up on the tax consequences. Nice post.

Report this comment
#9) On March 29, 2009 at 10:50 AM, arboretum (28.70) wrote:

kstarich:

Thanks for the thumbs up. The year end date in this case is not Dec 31, but whenever the capital distribution cutoff date is for that particular ETF. You need to sell it before the cutoff date, not the distribution date. You can get this date in the prospectus, it's generally around Dec 26th. In response to your request for more blogs like this here's my follow up.

belfairinvestor:

Fair enough, if you like gambling, and can afford to lose the capital involved, no problem. I personally was not using the ultras as a market timing tool (casino) but as a hedge to a long portfolio. It did not work out as well as I had hoped.

Report this comment
#10) On March 30, 2009 at 7:35 AM, ikkyu2 (99.38) wrote:

The legality of holding short- and other options-based ETFs in tax-deferred IRAs is, as I understand it, in a gray area.  Straight options trading and short selling is not permitted in those types of retirement accounts.  It may be that once the regulators catch up, they will declare ownership of options-based ETFs also against the rules.  Worst-case, retroactive penalties may be enacted.

Report this comment
#11) On March 30, 2009 at 8:25 AM, mattskin (< 20) wrote:

Just an FYI, I saw from another source that Proshares evaluates distributions (SDS in particular) on a QUARTERLY basis, not just annually, FWIW.

Report this comment
#12) On March 30, 2009 at 8:44 AM, moerequity (< 20) wrote:

you mentioned SH as being a safer way to play the down side for the S&P, but this is an ETF that uses leveraged investment techniques. How is this one safer?

Report this comment
#13) On March 30, 2009 at 12:41 PM, arboretum (28.70) wrote:

Thanks guys.

I was aware of some legality issues with holding these ETFs in tax deferred IRAs but did not think that retroactive penalties had been proposed. That would be pretty tough. My understanding is that some (rich) people have their retirement in hedge funds also. And a lot of people have money in stocks like GS that make a lot of their money from options trading. So there are clearly shades of gray here. But as ikkyu points out, it might be wise to avoid option-based ETF vehicles in tax-deferred accounts.

Quarterly distributions: Heads up everyone because my post does not give the whole story.

Proshares does indeed give quarterly capital gains distributions. It's just that the first three quarters of 2008 they did not make many. Most of their funds made (often large) distributions at the year end, which is when I was caught. This quarter may again see substantial distributions so beware.

SH is in my opinion only only safer because it is 1x inverse the index not 2x, and the volatility decay is less steep. It's only safer, not safe. I really don't recommend it either, and it also makes distributions and has the same tax issues. As I said, if you have to use a short vehicle, it's safer than the ultras, but I'd advise against it.

 

 

Report this comment
#14) On March 30, 2009 at 9:06 PM, isusan (< 20) wrote:

Hope this helps somebody!

It did!  Thanks!

Report this comment

Featured Broker Partners


Advertisement