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Leveraged ETF Myths 1 – Shorting Both Bull and Bear

August 17th, 2009 Kevin 2 comments

The Myth

In light of the incredible decay seen in leveraged ETFs in the past year, many have suggested shorting both the bull and bear leveraged ETF to profit from the decay (such as FAS/FAZ). The belief is that over enough time, both ETFs will either decay toward 0 or do reverse splits. Hence, the myth is that the pair shorting strategy is a ‘can’t lose’ strategy and a one way ticket to profits.

The Flawed Assumption

Unfortunately, this myth is based on the assumption that leveraged ETFs always decay more than they grow over long periods. In the period from October 2008 to March 2009, this was most certainly true as the markets saw such incredible volatility that caused leveraged ETFs to decay up to 20 to 40 times more than normal. This period has ‘colored’ people’s thinking, making them believe that leveraged ETFs will always behave this way and that any long term investor will most certainly lose money. The belief that leveraged ETFs always decay more than they can grow is simply not true. All it takes is some simple simulations to prove otherwise. Simulations show that there periods where the decay is greater than the growth and that there are also periods where the growth is greater than the decay.

The Risks

Like any other strategy, shorting both ETF has its risks. In order for it to work, it needs certain conditions to be met. Just like ‘going long’ requires the market to go up in order to profit, the paired shorting strategy requires the market to be horizontal or exceptionally volatile in order to profit from the decay. When these conditions are not met, the shorting technique can result in significant losses.

Example #1 – A Recent Trend

An excellent example that has probably blown out anyone recently attempting the ’short both’ strategy is the recent gains of many leveraged ETFs since the March bottom. Case in point, TNA:

 

A 240% increase implies a massive loss for anyone holding a short through this period. Even though there was 15% decay during this period, the trend was too strong. A chart showing the paired shorting profit through this period is shown below.

 

At one point the strategy is down 98%. This is certainly damaging to one’s confidence in this strategy.

Example #2 – A Bull Market

Advocates may say that the previous example did not give the strategy enough time to work itself out. Well, let’s run a simulation to see how it holds up in a bull market. By applying a 3x multiple on IWM’s data from 2003 to 2007, we can get a simulated version of both TNA and TZA during the last bull market. Running the strategy yields the following results.

 

A 400% loss is definitely not a one way ticket to profits.

Example #3 – S&P 500 (1950 – 2009)

We can take this strategy to the extreme by seeing how it would work over the course of almost 50 years of S&P 500 data. Again, a 3x multiple is applied to simulate a 3x bull and 3x bear ETF (such as UPRO and SPXU). Unfortunately, running the strategy over this timeframe results in such a drastic loss, plotting a chart shows astronomically high losses that make the chart difficult to read. Only a partial chart is displayed to make it somewhat readable.

 

Coming in at over a 100,000% loss, this strategy clearly did not work over this long period.

Myth Result: Busted

While there are periods where the pair shorting strategy works (like volatile bear markets), there is ample data that proves it fails to work during a multitude of conditions and timeframes. Hence, this myth is busted. For more coverage describing the challenges of this strategy, read this:

Why your brilliant plan to short a pair of 3x ETFS will not work.

Articles describing the pair shorting strategy:

Triple Leveraged Arbitrage
A Winning 2X and 3X ETF Long Term Strategy
The Equal Short Bull-Bear As The Ultimate Negative Correlator?

Shorting 3x levered bull and bear ETFs: Possibly a very cool strategy
Shorting Leveraged ETFs – Low Risk High Gain Potential?

Disclaimer: Results do not take into account any borrowing costs, transaction costs, or leveraged ETF costs.

Categories: Myths Tags: , ,