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Triple Leveraged Arbitrage
Posted on May 28th, 2009 15 comments
This is a long term play you’ve NEVER heard of. Its not quite arbitrage, but it does have some similarities. Its similar to an arbitrage strategy in that you have a long position, and a short position on the same underlying. In other ways its like selling call options dated fairly far out, in that the odds are highly on your side, and it should slowly but relatively safely make money over longer time periods. Yet the reality is this play is like nothing you’ve ever seen. I call this ETF strategy: Triple Leveraged Arbitrage.You may have heard of the phenomenon known as the triple leveraged ETF. This type of ETF aims to mimic 3 times the daily performance of a sector or index. The most popular are probably FAS and FAZ, offering triple the performance of the financial sector, and inversely triple the performance on a day to day basis. This means that if the financial sector goes up 1% in a day, FAS will go up 3%, and FAZ will go down 3%. That being said, this correlation doesn’t work in the long term.
If Financials go up 5%, then down 5%, then up 5%, then down 5%, then for arguments sake, up 0.5% to get them back where they started, then the assumption many will make is that the triple leveraged ETFs will ALSO be exactly where they started. Yet this is not so; the performance of FAS would be up 15%, down 15%, up 15%, down 15%, then up 1.5%, for a total loss of 3%. The performance of FAZ would be down 15%, up 15%, down 15%, up 15%, then down 1.5%, for a total loss of 5.9%.
Both the ETF that goes up as financials go up, and the ETF that goes down as financials go up, ended up down with the same price action. This is because of a small mathematical hiccup in the compounding, and is the reason why both ETFs state many times, very boldly in the prospectus, that these are intended as a daytrading vehicle.
If you don’t think it adds up, consider this. FAZ and FAS were both launched on the same date around $55 per share. At the time of writing, FAZ is trading at 4.96, and FAS is trading at 9.71. Also of interest is the fact that the underlying index is down, yet the bullish triple leveraged etf outperformed the bearish triple leveraged ETF. Another compounding hiccup.
The fact of the matter is that given any amount of volatility, these triple leveraged ETFs are quick to fall. This is why they are recommended as daytrading vehicles only. Thing is, I’m not a daytrader, so now I’m wondering, what’s the best way to use these things?
Their characteristics
-They get slaughtered by high volatility, and sideways markets
-They come in both the bull and bear variety
-Low volatility DOESNT benefit them (they won’t outperform due to low volatility, they just won’t underperform as badly)
-They have wild daily fluctuations
So what’s the best way, aside from daytrading, to use them? The answer is to short them, because of their natural, mathematical tendency to go down. Yet the wild fluctuations are likely to produce excessive volatility, and some excess losses to. How to solve that problem? That’s actually fairly easy. Just short both the bullish ETF, AND the bearish ETF. That way, one of the ETFs will be ahead at the end of EVERY day, and over the long term, you should see very high returns on both. An example; FAZ and FAZ both started at 55-60. They are now at about 5 and 10 respectively, after 7 months. Shorting both would have led to 92% and 83% gains. While they are something of a best case scenario, as there have been giant rallies, giant pullbacks, and massive amounts of volatility over that 7 month period, that just goes to show you what these things can do.The thing you have to watch out for just shorting both of them is getting wiped out by short term swings. Without frequent rebalancing, the direction that goes up in the short term could lead to the position sizing being highly skewed (a short position becomes a larger and larger position as it goes out of your favour, smaller and smaller as it goes in your favour). If you DO frequently rebalance, the excess commission costs could damage the portfolio, although it WOULD give you a systematic way to pyramid your profits (the rebalance would involve covering shares on the losing position, and shorting more shares of the winning one).
Definitely a high maintenance strategy. The alternative would be to use put options on both ETFs. The downside here is that the high implied volatility cuts into profits. This could be offset by using a vertical spread, not unlike the ones I discussed in my article, “the vertical leap”, the one difference being you would buy the higher strike option, and sell the lower strike option, making it bearish. That would offset the high implied volatility, while still staying true to the basic idea. As an added plus, it greatly limits the amount of risk you take on while waiting for the mathematical compounding effect to do its job. That being said, its not really ideal if your not confident trading stock options. Its also not ideal in the less liquid option markets, for although the options for FAZ and FAS are fairly liquid, other triple leveraged ETFs don’t necessarily have the option liquidity to support such a setup.
So what are some ETF pairs that this could work on?
underlying Triple leveraged Bull Triple leveraged Bear Financials FAS FAZ 10 yr treasury TYD TYO 30 yr treasury TMF TMV Developed markets DZK DPK Emerging markets EDC EDZ Technology TYH TYP energy ERX ERY Smallcap TNA TZA Largecap BGU BGZ
So there laid out is a nice arbitrage-esque strategy designed to take advantage of volatility in the markets. Personally, I think for the lower volume pairs, shorting both pairs, and rebalancing every 2 weeks would be the best strategy. For the higher volume pairs, a 2 strikes OTM vertical spread with max profit of at least 80% expiring 9 months to a year out would be my favourite play.Now one thing that you should keep in mind is that this is much closer to a buy and hold play then a short term play. If you hold for a long enough time period, then the strategy is almost guaranteed to pay off, based both on empirical results, and the effect of mathematical compounding. However, in the short term, this strategy is bound to lead to some losses, those losses of which have the definite potential to be large losses. If you’re going to try this strategy in your portfolio, please keep the amounts risked very small, and approach with caution.
Personally, if I was to use this strategy now, I would use either financials, or technology, as they are likely to be the most volatile over the next year, and volatility is where the returns from this strategy come from. Emerging markets would also be a good possibility for this strategy. In terms of the triple leveraged treasuries; I frankly have no idea how well it would work, but feel free to weigh in with your opinion.
So what do you think; we know buy and holding won’t work with these leveraged ETFs, but how about a short and hold? Does the idea have potential? What are your thoughts on rebalancing? Leave your comments to discuss!
Post Discussion EDIT: So as many of you have pointed out, its very difficult to find shares to borrow to short these ETFs with, and if the broker has low inventory of the ETFs, you also run the risk of having the position closed at a bad time. With that in mind, the major options become a) Using Puts to take advantage of a downside move, and using a vertical option spread to take advantage of the downside move. I’ll go over using options for a bearish position in the near future, but in the meantime, for those with a solid amount of options knowledge, what are you thoughts on that?
Market Commentary Arbitrage, BGU, BGZ, DPK, DZK, EDC, EDZ, ERX, ERY, ETF Investing, ETF trading strategy, FAS, FAZ, investing strategy, long term investing, sector rotation, sector trading strategy, shorting, Shorting Ideas, Shorting Stock, stock market strategies, stock option strategy, stock trading strategy, TMF, TMV, TNA, TNZ, triple leveraged ETF, TYD, TYH, TYO, TYP15 responses to “Triple Leveraged Arbitrage”
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they will not let you short faz or fas, its been tried
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This is not guaranteed to work since the bull 3x can still run away to the upside if the market recovers like 2003-2007. Basically the upward trend and compounding is stronger than the decay due to volatility. I’ve done significant research into leveraged decay with software I wrote myself. I will be posting results on my blog in the next week or so.
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Jordan May 29th, 2009 at 13:15
Ability to short FAZ or FAS has to do with your broker. I know some brokers allow it, some don’t. Also keep in mind I’m not recommending a huge portion of your portfolio go into this strategy. 2-5% is all that i’d recommend, given the potential for a long trend to cause intermediate term losses.
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Jordan May 29th, 2009 at 13:20
Kevin,
That is indeed a strong possibility, however i suspect your not taking into account the rebalancing. If you rebalance every time you have a 25% loss or 25% profit on one of them, then that would a) make the losses smaller, as your reducing the size of the losing short position, and b) make the profits larger, as your resetting the size of the profitable short position to a larger position overall.
That being said, i acknowledge that if we got a strongly trending market with little volatility, this would likely lose money.
What about if you use an options strategy though? That’s a good work around to the potential “infinite” loss people talk about in shorting
-Jordan -
Keven. What is the address of your blog? Would someone speak more about the rebalance? As pointed out this is a major problem. Let’s say you shorted both on 3/6. FAS was at 2.64 and FAZ was at 104.07. On 5/8 FAS was at 12.54 and FAZ was at 4.49. Thus, you would be up 90%+ on your FAZ short. But you would be down 300%+ on your FAS short. (Of course, if you did not get blown up by a margin call everything would be back to normal.) However, the rebalance seems not to work.
Let’s suppose both were at 10 today. And you shorted both with 1000 each. tomorrow fas is at 15 and faz is at 5. You are even because you lose 500 on your fas and gain 500 on your faz. If you buy to cover some of your faz (your winner) and then sell more fas short, to rebalance, won’t you be in even a worse position if FAS continues up on day 3? Now you will have even more shares shorted on the losing side than you did before. -
Also, would you post a link to your article on using puts. I think this one will be hard to use because both FAS and FAZ are so low now that your upside is limited. And it will be hard in other etf’s because the volume of the options is so low.
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Jordan May 29th, 2009 at 15:14
Alex,
You made a small error in the statement about the rebalancing.
if they are both at 10, and you short both with 1000, then you are short 100 shares of each.
If FAS goes to 15, and FAZ goes to 5,then your now short 1500 worth of FAS and 500 worth of FAZ. so you would double the size of the FAZ position up to 200 shares, while selling a third of the FAS position, down to 66 shares.If your short, and you rebalance, then your COVERING shares of the LOSER while shorting more shares of the WINNER, because as a short position goes against you, the position becomes larger. That’s where the infinite risk in shorting comes from. By rebalancing, your reducing the number of shares in the position that’s going against you, and adding to the number of shares in the position that’s going in your favor.
The article where i talked about long term option spreads is here: http://stocksandoptionsguru.com/investor-education/stock-option-strategy-the-vertical-leap/
While I talk about using options spreads in a bullish context, you could also use them for a bearish play by buying the higher priced put, and selling the lower priced put. -
would not work for a market with a clear trend.
assuming $100 trade and $100 stock price.
example: 10% up day for 3 days.
100 * 1.3 * 1.3 * 1.3 = $219 .. shorting nets .. -$119
the other side
100 *0.7 *0.7 * 0.7 = 34.3 for gain of $65.7
Net loss = - $53.3 -
Jordan May 30th, 2009 at 14:38
Thongthew,
I agree that in a market that is strongly trending, this strategy is probably not optimal, but your not looking at the potential for pullbacks.Lets say 5% up days for 5 days, then 2% down days for 3 days.
100*1.15*1.15*1.15*1.15*1.15*0.94*0.94*0.94 = 167
On the other side,
100*0.85*0.85*0.85*0.85*0.85*1.06*1.06*1.06 = 53That’s a total loss of $20, or 10% of total capital, even though there was a strong trend in progress. I see this as closer to a worst case scenario.
If you think the market will trend strongly one way or the other, it isn’t an effective strategy. If you expect a lot of volatility, but not a strong, continuous trend in one direction, then this play can work.
as shown with the financial ETFs, both starting at 60, both being 10 and under.
as shown with the smallcap ETFs, both starting around 60, currently at 27 and 24.
as shown with the largecap ETFs, both starting around 60, both now down to 35ish
as shown with the energy ETFs, both starting around 60, now at 35 and 20.
Long term, it seems to be a profitable strategy. Unless we break into a raging bull market, it should work. -
Monsoon May 30th, 2009 at 18:11
So far it seems that shorting these securities is highly restricted. The only pair I could find available (through Schwab) is TYD/TYO but the volume is so small and the bid-ask spread so large that it doesn’t seem such a good deal.
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I posted the analysis on decay:
http://blog.quantumfading.com/2009/06/01/leveraged-decay/
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Monsoon June 3rd, 2009 at 23:34
Actually, it looks like rebalancing is just what you DON’T want to do. I ran two simulations on FAS and FAZ over the past 7 months, one without rebalancing, one with rebalancing every day (assuming no commissions). After one year, with rebalancing, every dollar shorted would only be down to 69 cents (it gets even worse with trading costs of course.); without rebalancing, down to 13 cents. Of course, there is more fluctuation. That $1 went to $1.26 in the first 10 days, before nosediving. But if you have some elbow room, it seems that the right strategy is just short and hold. Now, all of this is very academic, if you can’t borrow shares. If anyone knows of a way to do it, please let me know!
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Jordan June 4th, 2009 at 01:18
Interesting, I wouldn’t of thought it would turn out that way. The thing with rebalancing is that the results will vary drastically depending on what criteria you use to rebalance.
In that respect, rebalancing the portfolio is *almost* like an exit strategy, in that it vastly changes the results. I posted a little update at the bottom of the article. While some brokers will allow you to short these things, their are risks in that the low broker inventory can lead to problems like exorbitant charges for these shorts, and the position being closed at inopportune times. What do you guys think of using puts? -
Monsoon June 5th, 2009 at 21:54
Update: there are a few pairs of double (not triple) gain ETFs that can be shorted. Their availability changes from day to day, so you just have to try your luck.
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kenny yuman June 6th, 2009 at 18:20
With IB, my short positions in ERY were bought in twice. I got a warning on potential buy-in on FAZ.
Worse, after noticing huge amount of interest charge, I found that I was charged at over 20% on short borrowing on FAS. I switched to UYG since. In general, Direxion bulls carry high rates.
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mburts May 29th, 2009 at 02:05