Saturday, February 21, 2009

More On ETF Decay

First, visit - ETF Daily Compounding.

Lately, more than a few traders have reconsidered *ETF decay* and its effect on their trading strategies. If all of these daily-compounding, leveraged ETFs spiral downward with back-and-forth volatility, over time, then why not short them AND short the underlying?

Even better would be to short two decay-ers against each other! Consider two relatively new ETFs - Direxion's Financial Bull 3X Shares and Financial Bear 3X Shares. They've only been around since the end of November.

Since, theoretically, they should track oppositely, why not short them both?

So on one hand, you are *triple long* and on the other you are *triple short*.

If you're still perplexed, remember that -(-1), "negative, negative one", is also equal to just "1".

Say that a savvy trader shorted $100,000 of each at the beginning of our time period.

It's not too clear, but it looks like FAS started at 14.62 and FAZ started at 165. (I've truncated the first day of trading and started with the second day's close.)

So our spread began by shorting 6,840 shares of FAS and shorting 606 shares of FAZ.

FAZ closed at 72.50 yesterday and FAS closed at 4.90. Therefore, our P&L looks like this:

FAZ profit = $56,065

FAS profit = $66,484

Total profit = $122,549 !!!

And that's from shorting 200k worth of equity, a margin commitment of roughly only 100k....and in only 3 months time!

It seems that *decay* is greater for these ETFs when volatility and leverage are both high - the latter meaning that a *triple* ETF will erode more rapidly than a *double*. Forget *seems*, it's very simple to mathematically verify.

So where's the risk in this spread?

Maybe these ETFs are too hard to borrow - for the little guy trader at least.

I'm going to have to contemplate it some more.

And I'm definitely going to have to alter my strategies with SRS, SKF, TBT, and DXO.

Why should I trouble myself betting on *direction* when there's free decay, free theta, to collect in low risk arb spreads?


Funny Circus Bears said...

Interesting. THEORETICALLY like selling levered theta without fighting the wicked bid/ask spreads.

Plus with shorting vs. options you are less exposed, like all theta or gamma sellers, to "eating like a mouse and shitting like an elephant".

This is worth further study!

auntulna said...

I thought I would try this with some that have been around longer.
For shorting:

SSO, 10/31=$32.47 3080 shares
02/20=$19.03 gain $13.44x3080=
$41,272 profit

SDS, 10/31=$84.19 1188 shares
02/20=$91.00 loss $6.81x1188=
$8077 loss

net gain $33,195

I hope I did that right, but it looks pretty interesting. I will run more examples soon.

Taylor Conant said...


Wasn't the 3-month period you sampled a period of relatively low volatility, a period in which these levered ETFs tend to decay more rapidly versus a highly volatile period in which they can see extreme share price rises?

I am not as sophisticated as you guys so I don't know if I sound like an idiot. Also, why hasn't anyone else picked up on this and started arbitraging the shit out of it yet?

Taylor Conant said...


My friend draws my attention to this post:

Have you read it? Any thoughts?

CaptiousNut said...


Volatility has been high. The higher the volatility, the more the decay. So you have it backwards.

That 'old bag' you linked to isn't saying anything that I haven't covered. And I think I said it much better.

A major issue with *short ETF arbs* is borrowing the shares. I'm going to try to short some stuff tomorrow just to see if my broker permits.

We'll stay on this subject this week. The prospect of risk-free ca$h is too important to gloss over.

Taylor Conant said...


Okay, I get it now. High volatility accelerates decay because the amplitude of swings has increased, and -10% of a number is more than -2% of a number, por ejemplo.

After reading that "female trader's" (sniggle... sounds as unintimidating as a she-police) post I actually got it right away, but maybe that's because I had first read your posts and then spoken with my friend of superior intelligence, then read her article. I don't know why I didn't get it when I read yours at first... really had me scratching my head.

My friend said Minyanville was covering this recently as well, so I am beginning to think that your posts were also nothing that THEY hadn't already covered ;)

I'm definitely looking forward to more coverage of this, though I am afraid that my broker (Scottyboy) probably won't allow me to take advantage of this "risk-free" money. So I'll have to pursue this angle from... another... angle.

Funny Circus Bears said...

I use IB and TOS (for options). Since these are new issues and the vast majority of shares are daytraded (I believe) and not "owned", the short pool is likely very shallow.

I'll find out tomorrow.

CaptiousNut said...

That's right Taylor, lots of people have covered it....

....and you still got it bass-ackwards wrong!


auntulna said...

Using the same method I used above, but from 1/02/09 thru 2/24/09 yields a gain of only 1.4% shorting SDS and SSO. Is it likely that these distribute dividends at end of the year, thus losing value?