Why you should be cautious about shorting ETFs
This is a followup to this post which was inspired by the discussion on CAPS about the dangers of the so-called "ultra ETFs". A lot of new (or newly troubled) investors are clearly looking at the way a lot of CAPS all-stars make points from red-thumbing stocks and are interested in ways to make money from falling stock prices. I discussed the most common ways to do this in my last post, along with why all of them are more dangerous than holding long positions in stock.
I'm writing this blog because after looking at the substantial amount of discussion on this on CAPS, I think there are still some misconceptions to be cleaned up about ultra ETFs. There are a couple of CAPS players to look at if you are interested in this.
UltraSuck red-thumbs all Ultras, on both sides of the market. I.e., both SSO and SDS, both FAZ and FAS etc.
volatilitydecay is a bit more selective and uses green and red thumbs according to market and volatility trends.
dirtyshorts went short the market at a very dangerous time, red thumbing bull ultras and green thumbing bear ultras, when arboretum thought that a major bear-market rally was on the cards.
I suspect all these are alter-egos of other CAPS players. I know for sure dirtyshorts is because it's me. The point is if you look at their score charts, especially dirtyshorts and ultrasuck (whose approach is brutally simplistic, unlike volatilitydecay), you will see that wherever they are at now, they have lost big at some point in time.
Another player you might want to look at is ktrotter79 whose standard pitch is " I recommend shorting this etf." This player has a point, in CAPS, in that red-thumbing (ultra) bear ETFs will be more successful than green-thumbing bull ETFs over time. The reason is as I said before, these ultras decay in price just like options do.
I hope ktrotter79 means "red thumbing in CAPS" by "shorting", not short selling. If anyone is thinking about short selling ultra ETFs, read this blog post and the comments, especially the comment by GoodVibe4Ever who has a good record of being helpful and honest with new investors.
I'm going to summarize the above now, adding my own $0.02:
Over time, Ultras lose value. Thus, short-selling any ultra should ultimately make you money in theory.
The first problem with this is that it's hard to borrow shares of ultra ETFs. This should be your first red flag. Any stock that is hard to borrow is prone to forced buy-ins - if the owner of the stock you borrowed wants to sell it, you might be forced to buy it back for them at the current price. This is especially a problem if your short is long-term, which it would need to be to be sure to make money.
An even bigger problem is that short selling can only make you as much money as the value of the ETF you short sell, because the value of the ETF you borrowed cannot go below zero. On the other hand, an ultra ETF can sometimes spike to 10x its earler price in a week or two. If this were to happen with an ETF you short-sold, you might get a margin call or a forced sale that could wipe out your entire portfolio. That's right, you could lose EVERYTHING pursuing this strategy if you are wrong, as GoodVibe wisely points out. Even if you short both sides of the market, such as SDS and SSO or FAS and FAZ. Since CAPS works on a percentage to the S&P basis, not a dollar basis, this problem is not evident in CAPS but could bankrupt you in real life.
Finally, since ultras are options, their price depends on volatility as well as decaying with time and leveraging the index. You can track volatility with the CBOE's VIX (not currently possible in CAPS). If volatility increases, then the value of both ultralong and ultrashort ETFs will be disproportionately high - i.e. if the market falls with increasing volatility, 2x ultrashorts will increase in value more than 2x the inverse of the index while 2x ultralongs will not decrease in value by the expected 2x the index. This is the reason why even in CAPS, ultrasuck took a serious haircut at one point - because by red-thumbing both FAZ and FAS, increasing volatility will lead them both to outperform expectations for a short period. Again, this could cause you a lot of problems if you tried to make money by shorting both sides, even if you used a more sophisticated, option-based strategy that avoided the problems with short sales.
My point is that while it could be possible to profit from this type of strategy without huge and unnecessary risk, it would require a very great deal of sophistication with options and arbitrage - vastly higher than my own level of competence and I suspect that of almost everyone else on CAPS. I have never done it, and I would advise anyone who knows the same or less than me never to do it.