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Trading strategies for inefficient ETFs – basic overview

11 Jan 2018,

Today’s part of my educational series will focus on specific strategies that can be used for trading inefficient leveraged ETFs.

I think, that those who read my articles on a regular basis understand, that keeping these products for a long time – to have these ETFs in the portfolio – is kind of financial suicide. I think I have given enough evidences for this claim in previous articles.

However, we have left the question about what strategies and approaches can be used for going short, respectively how to use the effect of the long-term decline of these ETFs.

In principle, I would divide these strategies into three cases:

ETF Short

 

Pair strategies

  • Double short ETF
  • Double short with options

Short ETF through options

  • Naked call (short call)
  • Securing of the option structures (long put, vertical bear call or put spreads)

I will devote to each of these strategies a separate part, some of those will certainly require even more parts.

 

  1. Short ETF

    Of course, the easiest and most straightforward way is to open a short position directly for the ETF. Looking at, for example, some ETFs linked to volatility and their development in recent years (often falling over 90% in 2017), many traders do not see any risks.

    That’s a big mistake. Often, in the exalted situation (in recent years, for example, the situation surrounding Brexit, Donald Trump’s victory in the presidential election), the ETF will become very strong in the short term – often by tens of percent per day.

    The following figure shows that in the days that either preceded or followed Brexit directly, the VXX developed strong growth – over 40% within a few days (and I note that we speak “only” about the non- leveraged ETF or ETN)

 

Graf vývoje VXX v období před a po Brexitu

Figure 1: VXX Chart before and after Brexit (source: finance.yahoo.com)

In the long run, the whole Brexit situation looks very innocent – virtually just like a tiny spike on a steady downward path (see the blue circle in the chart). But whoever kept a short position in the incriminated period certainly did not have a good sleep. Of course, it is necessary to point out that in the past years there have been significantly worse market drops, which have resulted in high volatility, and thus the growth of the VIX index and its derivatives by hundreds of percent. It is clear, therefore, that this is still a strategy with a high degree of potential risk, even if this does not look so regarding to the ETF’s long-term development.

 

Graf vývoje VXX v letech 2016 a 2017

Figure 2: VXX development chart in 2016 and 2017 (source: finance.yahoo.com)

But I certainly do not claim that a long-term short ETF cannot be considered as a valid trading strategy – and in another part of our series, I will analyse this method in detail on the specific strategy that we are currently trading for the gas in our fund.

My recommendation is, however, to avoid the extremely volatile and leveraged ETFs, where the extreme movement (though often short-term) against the open position is not an exceptional case. At the same time, it is necessary for long-term short to select such instruments that have a low cost (borrowing-fee, ie the cost of holding a short position in the given instrument).

For the entering itself, it is recommended to choose a situation when the market is not at its minimum (see current developments on ETFs linked to volatility) and on contrary enter to the trade at higher values of the underlying ETF. The whole issue of money management, entry and exit to the trade will be explained in detail in the following parts of the series; it is a complete alpha and omega for the successful trading of these ETFs.

Below are listed the main advantages and disadvantages of the short-term strategy.

Advantages:

  • Very high profit potential with a high probability of success over the longer term
  • Simple, straightforward strategy

Disadvantages:

  • Unlimited potential loss
  • The cost of holding a short position (borrowing fee)
  • Lack of shares for shorting (mainly for less liquid ETFs)

I will look forward to another part, where I will continue to analyze other suitable strategies.

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