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.