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Alternative approaches to shorting inefficient ETFs – pair trading (2/3)

22 Mar 2018,

In the last part of our series, we explained that pair trading of inefficient ETFs – more precisely the shorting of both ETFs in a given pair – may be considered as an interesting way to benefit from their inefficiency. But we have also said that in order to be able to think about trading ETF at all, it is necessary to meet several conditions. The first of them is liquidity – we have already spoken about it. Therefore, two other very important criteria are remaining, and these are the costs of ETF short and market volatility.

Shorting cost

I often get a question where the cost for shorting an ETF can be studied. I’m aware that most of you are using Trader Workstation (TWS) from Interactive Brokers. I will show you how to easily set up and find out the details of the annual borrowing fee.

Once you have started the platform, select any bookmark to enter the desired ETF. I named it a “short ETF”.

Next, click on any column name in the header and select “Insert Column before …” from the following menu “Short Selling” and sub-menu “Fee Rate. Confirm it and the new Fee Rate column appears.

Figure 1: Setting up a borrowing fee on the Trader Workstation (source: Interactive Brokers)

You now see clearly the annual percentage cost for shorting ETF. You can see that the number differs significantly for each ETF. For completeness, I also recommend you add the number of currently available shares for short- use the same procedure as for the borrowing fee but select “Shortable Shares” from the menu. If the number of available short positions is zero, it means that the ETF position will not be opened at the moment. When trying to open a short position, the broker simply tells you that the required number of shares is not currently available at the market, and that he will try to get the requested amount as soon as possible. Once the shares are ready, the information will come to you by mail (this happens in the case of Interactive Brokers).

If we consider the candidates from the previous article, then it will look like this:

Obr.2: Přehled ETF titulů pro short (zdroj: Interactive Brokers)

Figure 2: Overview of ETF titles for shorting (Source: Interactive Brokers)

So, we see that for some ETFs the annual fee for a short is very high (even over 15%). In the last article, I mentioned that we can consider as an ideal condition if the borrowing fee does not exceed %. As you can see, there are not many such ETFs in our report. However, more important than the total amount is to put this cost into line with its potential i.e. volatility of that pair – and hence its potential profitability. With higher volatility of the market these inefficiencies are reflected more. What, on the contrary, we do not want to see is a market that goes in one direction without any changes.

Volatility

And we are now fluently coming to the third criteria and that is the volatility. Let’s make a smaller comparison of the pairs. I have already mentioned in the previous article an interesting candidate for “pair short”, ie NUGT and DUST. Although the borrowing fee is higher than the 5%, it is still acceptable in terms of the potential of this pair. We can see a fairly curved volatile curve of both instruments, and both markets (NUGT -39.80%, DUST -6.68%) have weakened, which is exactly what we want. The following chart shows the development of NUGT and DUST for the past year (3 / 2017-3 / 2018):

Obr.3: Graf vývoje ETF: NUGT (modrá křivka) a DUST (červená křivka) (zdroj: finance.yahoo.com)

Figure 3: Chart of ETF development: NUGT (blue curve) and DUST (red curve) (source: finance.yahoo.com)

On the other hand, an example of a pair that is not an ideal candidate for pair short is FAZ and FAS. If we ignore the high borrowing fee at FAZ (almost 12% pa), the main problem is the very low volatility and longer movement in one direction. For the past year (3 / 2017-3 / 2018), there is the following development of both instruments:

Figure 4: ETF Development Chart: FAZ (Blue Curve) and FAS (Red Curve) (Source: finance.yahoo.com)

So, it is clear that we want to choose just such pairs as NUGT and DUST for the pair short, FAZ and FAS do not belong to our selection, it is very likely that we would realize losses even when the portfolio is rebalanced. In short – markets going in one direction simply do not fit for such types of trades.

For “homework” you can analyze other potential candidates for a pair short, you do not necessarily have to limit yourself to 3x leveraged ETFs. In the next part, I want to introduce you to both money-management strategy and the potential risks that this trading approach brings. The goal is not to frighten or discourage you from doing this sort of trade, but as it is a good habit when trading, it’s always necessary to keep in mind the potential risk and know how to control it.

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