Using the Leveraged Short or Long ETFs in a Trade

[tjlocke99 18]

I could use some help on this thought experiment. There are ALOT of 2 and 3 times short and long ETFs out there now.

http://etf.stock-encyclopedia.com/category/short-etfs.html

They typically very much underperform the actual index they match over any length of time because of the daily re-balancing they have to do.

For example from the Proshares site:

"Each Short or Ultra ProShares ETF seeks a return that is either 3x, 2x, -1x, -2x or -3x of the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next. Due to the compounding of daily returns, ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. These effects may be more pronounced in funds with larger or inverse multiples and in funds with volatile benchmarks. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily. For more on correlation, leverage and other risks, please read the prospectus."

SO what I am thinking is, is there a way to:

Long a bear ETF on the index AND then short the 3x bear in a 3:1 ratio (let's say for a month) or long a bull ETF and then short the 3x bull in a 3:1 ratio? Since they are not the same symbol though any short position, whether directly in the underlying or in a naked short position would likely NOT be treated as a hedge by your broker right?

Here would be a sample:

Right now on 6/22 @ 0011 ET

SPXU is at 51.68

July 51 Put Bid/Ask is:

2.65 / 2.90

SPY @ 132.44

July 132 Put Bid/Ask is:

2.46/2.54

so 3 SPY positions would be roughly equivalent to 8 SPXU positions (3 * 132 ~ 396 and 8 * 51.68 ~ 410; you could get closer by changing the quantities a little here), but you need the 3 times the coverage so you do 9 SPY and 8 SPXU contracts.

so lets say you did this:

short 8 of the SPXU puts @ 2.77 ea = 22.16 credit

long 9 SPY puts @ 2.50 ea = 22.50 debit

net debit = 0.34

so then you hold. theoretically the SPXU underperforms the SPY. If SPY crashes your covered with your long SPY positions. If SPY goes up quickly you may break even again. If SPY moves slowly in any direction or stays flat you profit.

Now their are obvious problems with this specific trade, including what I said about the broker and seeming naked on the SPXU. HOWEVER perhaps there is a different way to play this?

Any thoughts?

Thanks!

[Rogers 263]

I honestly can't say that I have studied the above theory... However the words naked and leverage scare me.. I like defined risk if possible.

[Kim 7,943]

When dealing with leveraged products, the spreads on options will usually make the trade not very practical. I remember looking into some possible trades a while ago and didn't find any significant edge. But let me look into it one more time.

[LSS 1]

"short 8 of the SPXU puts @ 2.77 ea = 22.16 credit

long 9 SPY puts @ 2.50 ea = 22.50 debit

net debit = 0.34"

How is this a hedge?

SPY goes up x%, SPXU goes down 3x% --> price of SPY puts drop (you lose money on your long puts) & price of SPXU puts goes up (you lose money on your short puts) --> You will lose money when SPY goes up.

SPY goes down x%, SPXU goes up 3x% --> price of SPY puts goes up (you make money on your long puts) & price of SPXU puts drop (you make money on your short puts) --> You will make money when SPY goes up.

[tjlocke99 18]

"short 8 of the SPXU puts @ 2.77 ea = 22.16 credit

long 9 SPY puts @ 2.50 ea = 22.50 debit

net debit = 0.34"

How is this a hedge?

SPY goes up x%, SPXU goes down 3x% --> price of SPY puts drop (you lose money on your long puts) & price of SPXU puts goes up (you lose money on your short puts) --> You will lose money when SPY goes up.

SPY goes down x%, SPXU goes up 3x% --> price of SPY puts goes up (you make money on your long puts) & price of SPXU puts drop (you make money on your short puts) --> You will make money when SPY goes up.

I think you caught a defect in my logic, but it just means you change one of the positions and there are a few permutations of how this could be played.

It should be:

long at 3:1 ratio of underlying price of SPY puts

short 1:3 ratio of underlying price of SPXU CALLS

A better alternate would probably be:

long at 3:1 ratio of underlying price of SPY calls

short 1:3 ratio of underlying price of SPXU puts

I hope this makes more sense.

But let's take a step back. The point is that the leveraged ETFs over any length of time over a few days will not return 3 or 2 times the index move because of daily re-balancing. Take a look at an historical chart on the S&P or other index vs a leveraged ETF. Is there anyway to SAFELY play this distortion? You can't short any of the leveraged ETFs I know but you can long and short options.

[Marco 223]

There is an SA article about the principle of this idea (underperformance of leveraged ETFs, short both long and short leveraged ETF to profit from that)

http://seekingalpha.com/article/201354-capturing-trendless-volatility-with-etfs

The trade performs in volatile but trendless markets. 2011 was fantastic for that, SPY was unchanged on the year but loads of ups and downs. Short 3x long (UPRO) vs. short 3x short (SPXU) would have delivered over 43% performance in 2011 (minus what it would cost you to borrow these ETFs). However if you get a strong trend (market up 20% in a quarter without much up and down) you'll lose money.

[tjlocke99 18]

There is an SA article about the principle of this idea (underperformance of leveraged ETFs, short both long and short leveraged ETF to profit from that)

http://seekingalpha....ility-with-etfs

The trade performs in volatile but trendless markets. 2011 was fantastic for that, SPY was unchanged on the year but loads of ups and downs. Short 3x long (UPRO) vs. short 3x short (SPXU) would have delivered over 43% performance in 2011 (minus what it would cost you to borrow these ETFs). However if you get a strong trend (market up 20% in a quarter without much up and down) you'll lose money.

So much for an original idea Thanks Marco.

I guess my thought was there to take advantage of this distortion with options? Is there a way to do it without selling a naked short position? Selling naked calls is ugly but selling naked puts is not so horrible (which are really not naked but would be treated by a broker as naked).

R

[Marco 223]

Don't really see a great angle with options. If you want to sell options you open yourself to the risk of a big move one way or the other. And if you go long (buy puts on both ETFs) the underperformance might not be enough (or all on one leg) to pay for the theta on both puts and leave you a profit.

So I'd stick with shorting both ETFs or go with other option strategies for the 'trend less volatile market' (IC's might work if Implied vol is high enough to pick wide enough strikes so that you stay in that range or can maintain a profit rolling your strikes once or twice)

[tjlocke99 18]

Thanks!