A different kind of straddle with etf’s?

A simple thought experiment. Some index ETF’s apparently have an inverse or 2X inverse “short” version. For instance, SPY and SDS.

Ignoring the expense costs, suppose the inverse ETF’s do what they aim to do: maintain the inverse or twice-inverse daily percentage moves of the reference index, then they are good for a particular kind of straddle strategy. Suppose you believe the daily prices of the reference index going forward are strongly directional (that is, if it goes up one day, then it may go up for several days afterwards, or if it goes down, then it may go down for several days). But, you don’t know which way it will be.

Then one way to get a potential gain from this is to take a purchase of both the forward and inverse ETF’s at the same exposure. That would mean 2 units of SPY and 1 unit of SDS, for example. Several days later, if the assumption is correct, then there will be a net gain, because the absolute gains coming from the “winner” ETF will be larger and larger with compounding, while the absolute losses from the “loser” ETF will be smaller and smaller. In the extremal case, the winner ETF goes to infinity and the loser ETF goes to 0.

Of course there is a cost for violating the assumption. The cost comes from the daily rebalancing of the inverse ETF’s. That would mean a path of reference index prices that fluctuates around the initial one. In that case, the inverse ETF loses value gradually, depending on the size of the moves. The 2X inverse ETF would lose even more. But if the realistic alternatives are small daily fluctuations or a few days of big directional moves, then this strategy wins. This seems especially appropriate for the current period.

Comments

  1. March 5th, 2009 | 21:55

    Very nice thought experiment. I had been pondering the very same strategy and found your post after searching google.

    I’ve been developing a simple spreadsheet to simulate EXACTLY these principles–and specifically the scenario involving only small movements in the market.

    Do you trade ETFs personally?

    Rob Hartop

  2. me
    March 6th, 2009 | 1:23

    I don’t do much trading, although I did simulate as well as try this for a few months earlier last year, before this post.

    It sort of worked. The downside insurance certainly worked for a while, but the inverse ETF’s bled too much and it’s totally opaque why. What I mean is, they really don’t track their respective indexes very well.

    The other practical issue is when to enter and exit these strategies. That is never clear.

Leave a reply