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[consultant]

I've been analyzing the effect of decay on these 2x and 3x ETFs. It's quite amazing. If you want to learn more Google a Morningstar article which is really good, search for keywords: warning leveraged etfs kill

I began to think, why not just short both the long and short fund then? The only risk is if a major long-term trend forms as I see it.

But think about this. What if you are reasonably confident about the direction of the long-term trend when it does form? Equities have taken a HUGE hit from the recession. We may have not hit bottom, but I think anyone can see with a reasonable degree of certainty, once bottom is hit, a long-term upward trend will form.

So what's been hit the worst? Financials. We've seen a run-up in financials in the past few weeks and a recent small pull-back as there is major uncertainty how financials will perform in Q2 and Q3. What's worse case scenario? The stress test results cause panic and financials go down 20-30%? But what are the chances they will rebound as the end of the recession draws closer. Pretty high in my mind.

So why not just SHORT and *HOLD* FAZ - 3X Financial Bear. I've read all sorts of spreadsheets and at some point you could suffer a 50-90% draw down, but at some point in say 6 months, you'll be up 50-90%, then just sell.

I found a blog post that speaks to precisely just that but hedges on both funds which bears the risk if a large trend is formed. I contest the risk can be eliminated by simply shorting the trend that is least likely to form in the long term. Just google: risk free short etfs I posted my comment to the blog at the end.

Wondering what do people think?

[TwosComplement]

Leveraged ETFs are designed to benefit the day trader. In your research, you may have already learned this, but I will explain on the off chance that you did not (plus, I am too lazy to do your recommended searches). Think about a 2% decline today and a 1% gain tomorrow. With a 2x leveraged ETF, 2% today equals 4% and 1% tomorrow equals 2%. In reality, the index or whatever the ETF is mimicking, is down 1% (-2+1=-1). Yet, with the leveraged ETF, the ETF is down 2% over the two day spread (-4+2=-2).

Leveraged ETFs perform very well on a day by day basis. However, they are a very big risk for any investment of longer than one day.

[consultant]

Yes, you just explained the basic premise of 'decay' In your example there was a 1% decay over 2 days. But you can hedge against the decay by shorting both the bull and the bear fund. Here's an example:

Bear $ % Bull $ %
100.0 100.0
110.0 10% 90.0 -10%
121.0 10% 81.0 -10%
108.9 -10% 89.1 +10%
98.0 -10% 98.0 +10%

In this example both funds went up 20% over 2 days then down 20% over 2 days. You would think you should end up back where you were, but as you pointed out, you don't. If you bought both of these funds you would have lost $2x2 = $4 = 4%. If you sold short both of them, you would have made 4%.

Obviously in the real world the number won't be that perfect. You can go to Google Finance and download price history of any fund write into Excel. I did it for FAS (3x Bull Financials) and FAZ (3x Bear Financials)

I ran calculations for a period for Feb 2, 2009 to Apr 21, 2009. One calculation assumed you bought at the open and sold at the close each day. The other one assumed you held the position for the entire time.

The largest cumulative loss on FAS for the hold strategy was 83% on 4/15 and 97% loss on 4/21 for the buy/sell strategy. But the largest cumulative return was 98% for the hold strategy on 3/6 and 75% for buy/sell on 3/6.

The problem here is that on the hold strategy you don't have to pump any more money in than the initial purchase of X shares on 2/2/09. On the buy sell, granted it is a mechanical buy at open sell at close, you would have lost 97% of your capital on 4/21, heck you would have lost 50% earlier, so you would need to pump in more capital so you could still afford to buy the same number of shares the next day.

FAZ is less volatile for some reason. May just be the timeframe I chose. If my spreadsheet is correct, for the same time period, the largest cumulative loss on FAZ was 70% on 3/6 for the hold strategy and only 26% on Mar 19 for the buy/sell. The maximum return for hold was 31% only 4 days after getting in and 38% on 4/28 for day trading.

The interesting thing to note that 3 of the 4 largest percentages, be it gains or losses for any strategy, are all losses. The hold strategy on both ETF's at one point were down 83% on FAZ and 70% on FAS. So you could have shorted either stock and held it, set a target profit at 50% and easily hit it within a month or so!

Of course past performance isn't an indicator of future performance but I'm thinking about this strategy.

Simply short the fund that you think is counter to what the trend will be and HOLD it but set a reasonable profit target. Since these things are 3x leveraged the decay plus the leverage means that at some point you'll be way into positive territory and at some point you be way into negative territory. The only way to lose your money would be if a HUGE trend formed and it never came back. Even if the financials collapse for the rest of the year, they will eventually come back so you may be sitting on a 90% draw down for 3-12 months but eventually you'll make tons of money when it comes back.


This doesn't work for the day trader that is using the profits for their monthly income. They can't afford to sit on a draw down for more than a few weeks unless they have reserves to pay the bills while they wait for it to come back.

One could argue how can you be so sure the trend will be up in the long term (I'd just point to the finacial sectory historical price history.) But technically you can never be 100% sure. Even so, you could reduce your risk that you guessed the trend wrong significantly (and reduce your potential gain) by shorting both funds. Here's a simple example where you own both when the market ranges then forms a trend. You can see that you have a gain as long as the market is going up and down but once a trend forms you lose your edge and end up with a loss, albeit it only a 13.6% loss (remember we are short on these two funds not long). This example is showing the market first ranging then forming a down trend instead of up (so the Bear fund goes up.) If we would have been short only on the Bear fund (assuming the financial sector would eventually enter a bull trend at the end of the recession) we would have lost 56%. My contention is the tread is going to be up eventually. So I short the Bear. When you are short, the decay works for you rather than against you in a volatile market.

Bull $	%	Bear $	%	Cumulative
$100.00		$100.00		0.0%
$110.00	10%	$ 90.00	-10%	0.0%
$ 99.00	-10%	$ 99.00	10%	-2.0%
$108.90	10%	$ 89.10	-10%	-2.0%
$ 98.01	-10%	$ 98.01	10%	-4.0%
$107.81	10%	$ 88.21	-10%	-4.0%
$ 97.03	-10%	$ 97.03	10%	-5.9%
$ 87.33	-10%	$106.73	10%	-5.9%
$ 78.59	-10%	$117.41	10%	-4.0%
$ 70.73	-10%	$129.15	10%	-0.1%
$ 63.66	-10%	$142.06	10%	5.7%
$ 57.30	-10%	$156.27	10%	13.6%