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arboretum (28.25)

Why you should be cautious about shorting ETFs

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March 29, 2009 – Comments (10) | RELATED TICKERS: SRS , FAZ , FAS

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.

 

 

10 Comments – Post Your Own

#1) On March 29, 2009 at 11:02 AM, mattskin (< 20) wrote:

Arboretum,

These are great posts.

I was aware of most of the dangers, decay, etc. ultras, but the tax implications of holding through the distribution date is news to me.

Another question:  Although these ETFs don't work perfectly when trying to generate 2x, 3x their underlying index, they are usually pretty close.  So while they utilize options that have both a time and volatility premium, wouldn't this mean the impact of increased/reduced volatility on ETF returnd is a minor one?  What is the true extent of this over/under performance due to volatility?  I think the bigger issue is that volatiltiy will accelerate the decay of the ETF.

Just wanted a little more explanation on this.  Regarldess, I am pretty much done with ultras given I have experienced the dangers you have outlined firsthand.

Thanks!

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#2) On March 29, 2009 at 11:06 AM, binve (< 20) wrote:

Another great post. Thanks!

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#3) On March 29, 2009 at 11:46 AM, Technicals (< 20) wrote:

The Ultra ETF's are day trading trading vehicles which track the index they are associated with 3x on a intraday basis, it has been brought to my attention that even holding positions on FAS and FAZ for a swing trade overnight is not a good idea because they reset daily. These are certainly not long term investment vehicles and are not advertised as such. Exchange traded notes (like DXO) are even more complex because the ETN is backed only by a promise to pay by some bank, I've seen DXO deteriorate over time in a big way and the lesson is to know what you are buying, and for me exchange traded notes are out of the question.

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#4) On March 29, 2009 at 11:48 AM, ReaganD (30.60) wrote:

mattskin, graph FAS vs. FAZ.  the volatility decay is massive

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#5) On March 29, 2009 at 11:59 AM, mattskin (< 20) wrote:

I am aware of the decay factor.  PErhaps I misunderstood Arb, but I thought he implied reduced volatility impacted the DAILY performance of the ETF.  I am asking if this is, in fact, what he meant.

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#6) On March 29, 2009 at 12:25 PM, Technicals (< 20) wrote:

I know of a day trading group online which was pulling 5-20% out of FAS or FAZ on a daily basis for months using intraday 1 minute charts on XLF for indications of short term trends and making an absolute killing. I often wondered who was supplying all this "dumb" money and now I think I know. If you do not understand the way an investment is structured, you should not be involved in it in my honest opinion.

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#7) On March 29, 2009 at 1:28 PM, arboretum (28.25) wrote:

Hi everyone

mattskin - the decay is most obvious on a daily chart as ReaganD points out, and I mostly put this blog up to warn the often very new investors that come across CAPS, but it does happen on a daily basis. You also see volatility gains on a short term basis - this was expecially obvious when we were dropping towards that bottom a few weeks ago, sometimes SDS was 2.5x or 3x the inverse. I assumed this was correlated with rising volatility but as Technicals points out it might be short-term manipulation or just excessive demand for that security on that day. There have also been days when both the S&P and SDS were down, this was true around Christmas when volatility was falling.

" If you do not understand the way an investment is structured, you should not be involved in it in my honest opinion."

Very true. How many of those involved in mortgage-backed securities or credit default swaps this time last year could really say that?

The problem is the prospectuses for these things can be downright misleading and there are few good resources for figuring this out. Hence the blog. Please feel free to post other good resources here too.

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#8) On March 29, 2009 at 2:02 PM, Technicals (< 20) wrote:

"Because Direxion Share ETFs seek daily investment goals, the Funds are not appropriate for "Buy and Hold" strategies, especially in volatile markets. Please read the prospectus and visit our Education Center before investing."

This is straight from the front page of www.direxionshares.com website.

 

To summarize, these are "daytrading" vehicles, to swing trade or try to invest long term in these is nothing but equal to throwing a bet down in Vegas, you are doing nothing but gambling. There can be no strategy! 

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#9) On March 29, 2009 at 2:41 PM, arboretum (28.25) wrote:

Technicals

My point is that it is possible to make a lot of CAPS points by betting on medium-term volatility decay on EFTs on opposite sides of the market. As a CAPS point making strategy, this works very well. Look at the players cited above if you don't believe me.

My secondary point was to do this in real life would be very difficult, very risky, and require a lot of skill with options and arbitrage. I would not like to say it is impossible. However, clearly, Direxion (or whoever) would not want you to do this, and would make it as difficult as possible for you to do it.

Finally, being a "day trade" vehicle is not the same as not being a "buy and hold" vehicle. When I had tax issues holding SDS over the year end (see previous blog) I was holding it in order to make my portfolio flat in case there were sudden movements over the break, when I could not attend to it for a couple of weeks. A short term hedge is not the same thing as a buy and hold strategy, and you are not warned against this in the prospectus.

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#10) On March 29, 2009 at 2:42 PM, ayekappy (< 20) wrote:

I'm a wuss, I never short anything, I only buy puts if I want to bet against something.

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