Wednesday, February 24, 2010

Levered and Inverse ETFs

How do you use levered and inverse ETFs on a day to day basis?

We have talked about the importance of using ETFs as diversification tools and also to gain quick exposure to an index, a market, a commodity and plenty other financial items. We also talked about the existence of levered ETFs (ETFs that use leverage to get a magnified exposure to the instrument they replicate) and also inverse ETFs (ETFs that move in a directly inverse way to the underlying instrument, which is basically the equivalent of getting short exposure).

It is important to properly understand the effects that leverage has when looking at the performance of levered ETFs especially if you intend to hold them for longer periods (and even any period longer than one day).

Keep in mind the actual definition of the ETFs that we are talking about today. Levered and Inverse ETFs are defined as ETFs that have a performance that is designed to follow the DAILY performance of a financial instrument (let's assume it's an index). So if it is a simple ETF it will have a performance that is the same daily performance as the index. If it is a double ETF it will have a performance that is twice the DAILY performance of the index. If it is a simple inverse ETF it will have the inverse of its DAILY performance and a double inverse will have twice the inverse of its DAILY performance.

Notice how the emphasis is in the word DAILY. These ETFs are designed to replicate DAILY performances (or multiples thereof). What would happen if we hold them for longer than one day?

In this example, there is an index that is being tracked with ETFs. Let's assume that the index itself has a value of 100 and that each one of the four ETFs have a starting value of 100 as well.

As you can see in the graphic the index and the four ETFs start with a value of 100 ($100 for the ETFs). At the end of day 1 the index has increased by 25% to 125 so the 4 ETFs behave as expected. The single one increases by 25% to $125 the double one goes up by 50% (twice the daily 25%) to $150 the inverse decreases by 25% to $75 and the double inverses loses 50% (twice the inverse of the daily 25%) to $50.

On day 2 the index loses 20% so the ETFs behave the way you would expect them to behave. The single one goes from $125 to $100 (same as the index, -20%) the double ETF loses twice the daily percentage change so it goes down by 40% from $150 to $90. The inverse goes up by the same daily percentage than the index went down by (so the inverse of the daily percentage change in the index 20%) so it goes from $75 to $90 and the double inverse goes up by twice the inverse of the daly change so in this case instead of -20% this one goes up by 40% from $50 to $70.

On day 3 the index loses a further 10% ending at 90 so the single ETF tracks it by the same percentage going from $100 to $90. The double goes down by twice the daily percentage so -20% from $90 to $72. The inverse goes higher by 10% (since the index went lower by 10%) from $90 to $99 and the double inverse goes higher by twice the daily percentage change so 20% higher from $70 to $84.

So what do we have at the end of 3 days? If you didn't know exactly how these ETFs work you would expect that at the end of 3 days with the index down by 10% you would have the double one down by 20%, the inverse up 10% and the double inverse up 20%.

In reality the single ETF tracks the index so that at the end of 3 days the total performance is as expected -10% but the double one which we would expect to show a -20% has an actual -28% performance. The inverse which we expected to be up 10% is actually down by 1% and the double inverse which we expect to have a +20% performance has an actual loss of 16%.

What happened? Don't these ETFs work?

The answer is that these ETFs work perfectly WITHIN A ONE-DAY HOLDING PERIOD. Once you go any longer than that their daily percentage changes are compounded and will not accurately track the indices over a longer period.

This is why as a trader I use levered and inverse ETFs only for day trading purposes and never to hold for any longer than the current day. As you could see in our example, instinctively once you know the index went down by 10% you would be so glad if you bought the double inverse 3 days prior expecting to see a 20% return on your trade and you would be extremely disappointed to find out that you actually lost 16%. In other words you were right on the direction and right to think of using leverage but you chose the wrong vehicle to carry out your trading idea.

Simple ETFs without leverage can be used without problem as you could see in our example, as they track the underlying index quite well (the companies that create those ETFs track the deviation from the index that their ETFs are tracking and it's normally neglegible). As such, those ETFs can be used in a long term investing portfolio, unlike levered and inverse ETFs.

If you do believe that an index is going down and would like a way to open a longer-term trade reflecting this what you could do instead of buying an ETF providing you with the inverse of daily returns for the index would be to simply short the ETF that tracks directly said index. ETFs can be traded like stocks and as such can be shorted and even have standardized options written on them. As a practical example, if you think that one month from now the S&P 500 is going to be trading lower than it is today and would like to open a trade that reflects this you would not buy SH (inverse) or SDS (double inverse) but you would rather short SPY to reflect this. If you, on the other hand, believe that the S&P 500 will be lower than it is now before the end of today you can safely buy either SH or to get some leverage even SDS provided you close out the trade before the end of the trading day.