Monday, December 08, 2008

1x1 of ETF trading

ETF is not ETF.

There are regular ETF's. These move in value comparable to the underlying index. A prominent example are the Spiders (SPI) or the Diamonds (DIA) which mirror movements in the S&P500 and Dow Jones index. So 1 point up in the S&P is a 0.1 point up in the spiders. No problems here. You may stop reading, if you trade just these. This article does not apply to these regular ETF's. Just make sure you have just these regular ETF's in your portfolio.

But there is a new kind of ETF's. These ETF's move the same percentage as the underlying index. Meaning if the underlying index moves 5% up, then the ETF also moves 5% up. If it's 5% down in the index, then these ETF's move 5% down as well. There is also a very hip breed of these percentage based ETF's, which give you double or triple the percentage move of the underlying index.

These percentage based ETF's show certain characteristics, which makes them great trading vehicles for short term swing trading, but make them very dangerous for investment strategies.

Let's look at a few examples to show my point:

You are long 200 DDM (Dow30 Ultra 2x long) ETF at 30.00.

Now consider two alternate scenarios:

1. Monday the Dow rises 5%, Tuesday up another 3%, Wednesday up 0.35%, Thursday up 2%, Friday up another 2%

or

2. Monday the Dow rises 2%, Tuesday up another 5%, Wednesday down 3%, Thursday up 5%, Friday up another 3.35%

Can you tell me which scenario your account likes better?

Lets look at another example:

1. Monday the Dow rises 10%, Tuesday up 0.5%, Wednesday up 0.5%, Thursday up 0.5%, Friday up 0.5%

or

2. Monday the Dow rises 2.4%, Tuesday up 2.4%, Wednesday up 2.4%, Thursday up 2.4%, Friday up another 2.4%

Or can you tell me how it is possible that a Long ETF and a Short ETF both starting at 50 when they start public trading, today trade both below 50, even if they both move the same percentage points?

EG: Long +10% is mirrored by the Short -10% and it is every day the same, still you can have both ETF's trading below 50. Is it all a sinister fraud a conspiracy to get your money? Or is it something different?

(First you have to remember, that a Ultra 2x ETF will move twice the percentage points the market made

Long DDM

30.00

1. Alt

Price

2.Alt

Price

Monday  

10%

33.00

4%

31.20

Tuesday  

6%

34.98

10%

34.32

Wednesday  

0.7%

35.22

-6%

32.26

Thursday  

4%

36.63

10%

35.49

Friday  

4%

38.10

6.7%

37.86

           
200 Long    

7620.00

7572.90

Paid    

6000.00

6000.00

Profit    

1620.00

1572.00

Interesting what that one down day made to your total profits, even if the percentages in both scenarios added up to 24.7% up.

Let's look at the second example:

Long DDM

30.00

1. Alt

Price

2.Alt

Price

Monday  

20%

36.00

4.8%

31.44

Tuesday  

1%

36.36

4.8%

32.95

Wednesday  

1%

36.72

4.8%

34.53

Thursday  

1%

37.09

4.8%

36.19

Friday  

1%

37.46

4.8%

37.93

           
200 Long    

7492.00

 

7586.00

Paid    

6000.00

 

6000.00

Profit    

1492.00

 

1586.00

 

Both percentages add up to 24% upmove, but in the first scenario we had a big upswing and then consolidation with an upward bias, while the second scenario was a typical rising market, nothing spectacular just relentless upward. The percentages add up to the same amount, still the results are different.

As far as I can see at the moment, ETF's are great for trading, but you don't hold them and forget them. Especially when you do some calculations to find the answer to my third question.

Why can 2 ETF's, which are supposed to mirror each other starting from the same price at 50.00 both trade below 50 after a while?

Meaning, if you invest 100 in the ETF long and 100 in the ETF short, your net should remain 0 after 1 or 2 or 10 years. But that is not the case and I hope you have an explanation as the answer might result in the decision to go short the Short ETF, when you intend to go actually long or Short the Long ETF, when you want to short.

That way you would trade the fund side of the ETF investment game and no longer the investor side. Investors buy either long or short ETF's, the Fund sells them and is therefore always Short.

Let's look at an example I just made up to show my point:

Globetrader_003

Assume you have a long and a short ETF and both started trading on 1.1.08 at 50.00.

We had a bit of a buying spree at the beginning of the year, reality setting in after 3 days and the market retracing over the next trading days, then just regular market madness, nothing spectacular, nothing you wouldn't expect from today's trading ranges. My example shows a regular and an Ultra 2x ETF. As you see, the Ultra results are just more pronounced.

Now within just 17 trading days an investment in 100 shares (10,000$) each of the Long and Short ETF is down 231$, in case of the Ultra you are down 902$. If you have 2 accounts and in one account you go long 100 shares of the Diamonds and in the other you go short the Diamonds. What is your net after 17 days, assuming an initial investment of 10,000$. Sure it's 10,000$, any gains in one account will cover the losses in the other account.

With ETF's it's different. Sure you get the expected result, if you go long 100 Long ETF in one account and short 100 Long ETF in another, but that's not how it is sold to the public.

The public goes long the Long ETF, if they think the market will go up and it goes long the Short ETF if they assume the market will go down ultimately.

Btw: The results are nothing sinister, no conspiracy, just the way ETF's are setup to trade. They mirror percentage moves and that means ETF's will always fall faster than they go up. And the higher the leverage, the more extreme the results.

50 -10% = 45.00
45 +10% = 49.50

Who is gaining? Well the Fund companies selling these ETF's of course. They are short the ETF's you go long and if you are down 1000$, they are up these 1000$.

But can't they lose? Sure they can. But in the long run statistics make sure, that any ETF will be likely to fall below the price the fund opened trading.

DUG is the Ultra Short 2x Oil & Gas ETF and you would assume that contract should be trading above it's highs

SharpChartv05.ServletDriver

DUG started trading at 69 in February 2007. SharpChartv06.ServletDriver

Despite the huge downward move in the Crude Oil price reflected in the Long Ultra Oil & Gas ETF (DIG) The corresponding Short ETF (DUG) is down. An investment of 100 shares in both the long and short ETF at the start of trading in February 2007:

100 DIG at 60 = 6000$

100 DUG at 68 = 6800$

Total 12800$

Today's value:

100 DIG at 27.35 = 2735$ Down 3265$

100 DUG at 32.99 = 3299$ Down 2701$

In other words, Going Short 100 DIG in February 2007 and going Short 100 DUG in February by selling you your position in the Proshares Fund has made the ProFunds Distributors, Inc. 6834$ (excluding commissions).

6834$ on an 12800$ investment in 1 and 1/2 years.
That's a 53.4% return on investment. Not bad, really not bad at all.

So shall you go Short the Short ETF, when you think the market is going up and Short the Long ETF, when you think the market is going down? The results point in that direction, especially if you intend to hold your ETF's for the long run.

ETF's favor the Fund company, if the market moves against the ETF (meaning the market is going down and you hold a Long ETF. Just look at these beaten down ETF's I have told you in recent articles about: DXO, UYG or URE). But they have great leverage and they will bring you good profits if you swingtrade them. Actually if you trade futures and you want to expand your trading into swingtrading, ETF's are a great way to do it. You are used to watching your positions like a hawk. You are used to fast adverse movements, which require instant action and you are not likely to panic in case the market is not doing what you expect the market to do.

Just know that the odd's in ETF trading favor the short side, that any long gains are most likely temporary, and even when an ETF trades 100% above it's initial open price, don't expect these gains to hold. Adverse percentage moves will make sure, that these ETF's can fall extremely fast and hard. A lot faster than stocks will fall.

13 comments:

Zlatko said...

You could buy non-levered ETFs

B-rad said...

Let me know when you figure it out

Jesse said...

That effect only happens with the leveraged (2x) ETFs. If you trade the XLF or IYM or SPY it doesn't happen. But you are right. The leveraged ETFS are terrible investments on the long side. However, if you have a margin account, you can short them using some brokerages (Interactive Brokers works) which offers some interesting possibilities.

Globetrader said...

Jesse,
don't fool yourself. This effect happens with any ETF, which mirrors percentage moves of the underlying index, average, whatsoever. If it moves the same percentage as the underlying you will see the effect I have discussed in the article. Just with non-leveraged instruments the effects are smaller.
10 - 5% + 5% is not 10 but 9.975
Best regards,

Chris

Bryan said...

So let me see if I have this right? I bought UYG the day Citi was melting down at a 1618 extension at 3.36 and also bought DXO at 2.55 the other day at a fib ext also. I was thinking of holding them for awhile. Financials have been so beaten down and as you said in your prior post oil also has also taken a beating and is cheap at this price. So these are not good long term holds ?

Globetrader said...

Bryan,
DXO, UYG, add URE (real estate) and UYM (basic materials), eventual DBA (agriculturals), have been beaten down a lot. And I myself am in and out of longs in UYG and DXO. Here the percentages play to your favor, as the downside is clearly limited in these ETF's.
Still the fact remains that they drop faster than they rise. And that means I will not lock a long position away, but always swing trade it. Taking nice profits, selling puts to get into the market again, eventually selling calls once I have a position worth mentioning.
Best regards,

Chris

Paul said...

Chris this is an excellent article on a topic that's not very intuitive to most people.

With respect to unleveraged ETFs, you mention that "if it moves the same percentage as the underlying you will see the effect". But don't Diamonds and Spiders which "mirror movements in the index", also move the same percentage as their underlying index each day? How do you make that distinction?

Globetrader said...

Paul,
unleveraged ETF's make the same percentage moves as the underlying index. Meaning the percentage mathematics also apply to these indexes. EG: If an ETF drops 50% it needs to make a 100% move to be breakeven again. Also they still might show leverage compared to the underlying index, if they don't trade at the same value as the index. EG: The spider trade at 1/10th of the S&P index. If you have an ETF, which trades at twice the value of the underlying index you have a 2xleverage, even if the percentage moves are the same.

Chris

Bob Brill said...

I saw Jesse's comment and the response from Chris/Globetrader but I'd like to push the point another time to gain from your wisdom, picking up on the idea "the odds in ETF trading favor the short side."

As a substitute for UltraShort Real Estate ETF (SRS), please let me know if you perceive any advantage in shorting the 2x Ultra Real Estate ETF (URE) rather than the 1X iShares Dow Jones U.S. Real Estate Index Fund (IYR). All comments and explanations are appreciated. I’m interested whether being on the short/opposite/house side of the multiplier ETF would work to my advantage.

Globetrader said...

Bob,
the problem is that URE trades already below 10 USD. (Same as the Ultra finacials (UYG) btw). And once an ETF trades below 10 USD, the percentage moves are no longer really big pointwise. 10% on a 5$ ETF is 50 cents. I'm actually looking into these beaten down ETF's to build a portfolio for the time, when the economy starts going again. That's the reason i prefer DXO over UCO (both Ultra long oil ETF's) even if DXO has a credit default risk, something UCO has not. With DXO trading at 2.30 USD the risk is limited, as I don't build a huge position, but limit myself to max 1.500 shares scaling into that position every 35 cents down (Long 2.66 and now another at 2.31).
So I would not short any ETF below 10 USD, as the downside is really limited.

Woodshedder said...

This phenomenon does not happen with the non-leveraged ETFs. What you are writing about is due to the leverage, and one other component that I do not believe you mentioned.

The other very important point (probably the most important point) is that the double ETFs seek to match the DAILY return. "Daily" is important here because it does not mean that the SSO will match the weekly, or monthly return of 2x the SPY or S&P.

You are confusing the fact that when you lose 50% it takes more than a 50% gain to make up that loss with what happens when one combines volatility and leverage.

Any index, security, whatever, will have more to make up in_percentage_terms than it lost on the way down.

However, the levered ETFs will lose more due to the 2x leverage and volatility and reseting daily.

If volatility goes to nil, and the market starts trending, the 2x ETFs will start looking like heroes. As long as we chop a lot, with large percentage moves in both directions, the leveraged ETFs will head to zero.

And finally, the SPY is not leveraged, neither is the DIA, or any other "non-leveraged" ETF.

DdC said...

Hi Chris:

Thanks for the interesting article. Unfortunately, I believe that it may be flawed.

I shorted a few bull ETFs (BGU and TNA) on 2/23 and 2/24, respectively. Out of curiosity, I took a look at the performance of the inverse ETFs (BGZ and TZA) over that same period. While you are correct that the bull ETFs have gone down faster than the bear ETFs have gone up, this is not the proper analysis in terms of return.

Using just TNA as an example, as of the last after hours trade today (3/3), it has lost 43.2% of its value since I bought it at 10:45 a.m. on the 2/24 for $17.10, while TZA has gained 40.3% over the very same period. So again, your statement that they lose value faster than they gain is correct. HOWEVER, I shorted 1000 shares of TNA, which cost $17,100. Today, those same 1000 shares are worth $11,940, a gain of $5,160 or 30.2% on my investment of $17,100. Had I instead taken a long position of 230 shares of TZA for that same $17,100, that position would now be worth $23,992 or 40.3%. The results are similar for BGU.

Is this an anomaly because the market has moved in the same direction over this period of time, or is your conclusion about shorting the opposite ETFs flawed?

Thanks in advance for your response.

Best,
Dave

Globetrader said...

Hi Dave,

looking at my example I notice, that to make my argument I started with the assumption, that the Bull and Bear leveraged ETF both started trading at 50, you invested at that level and then I looked at their performance. Simple mathematic behaviour let to the conclusion, that trading the Short of the opposite ETF and thereby trading like the fund itself, would give you better performance.

But as you are not the fund itself you can't invest at 50, you have to take whatever the market price is right now. And that means for a lot of leveraged ETF's:
The Bull ETF is trading below 20, while the Bear ETF is trading above 100.
It's worth a follow-up article to examine the behaviour of these ETF's, as below 20$, 10$ or 5$ big percentage moves translate in smaller and smaller $-movements, while above 100, 120 or 150 big precentage moves tend to be reflected in bigger and bigger $-moves as well.
I assume, that's what caused the discrepancy in returns.
Best regards,

Chris