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Trading System for Shorting inefficient ETFs – Part 1 – Basic Overview

5 Apr 2018,

In today’s part of our educative series, I would like to focus on how to start building your own specific trading system for shorting inefficient ETFs. Above all, I would like to focus on the basic blocks of such a system, which I will then discuss in detail in later chapters.

 

Market selection

First of all, we should focus on markets with good liquidity, significant inefficiency, tracking error, which tends to decline in the long run.

There are numerous overviews of such markets on the Internet. I chose for example finviz.com site, where criteria can be selected as filter parameters:

  • ETF (Industry: Exchange Traded Fund)
  • It is possible to trade/short through Options (Option/ Short: you can select Optionable, Shortable, or both)
  • Performance over the past year decreased by more than 50% (Performance: Year -50%) – this is a fairly subjective choice, it depends what you consider to be sufficient.

The result is here.

It may be possible to add other filter, for example, that in the current week, or in certain month the market is went up (Performance 2 – week UP or month UP), which would indicate that there is a short-term growth which may represent a potentially advantageous entry opportunity.

From my point of view, it is better to spread the portfolio to more different markets, ideally to spread it across different market sectors (eg commodities – gas, oil, … market volatility, individual sectors of the economy, …). Diversification should be made at least to 3-5 such markets.

 

Trading strategy

It is very important here which concept (conservative vs. dynamic) you prefer. If you do not have problem to risk more and you are having a larger account, it is possible to trade a decline in the price by direct shorting of the given ETF. However, there is a need to have a very strict trading plan and, in case of unfavorable development, to leave the position accordingly.

 

Although we will be speaking about the management of direct shorting in other parts of our work, I would rather move your attention to option strategies. Here, it is possible to focus on strategies that have by their nature limited risk (eg long put, vertical spreads, etc.), which is typically represented by the expense for the opening the trade based on given strategy, or a limited margin for spread position. The advantage of the options is that there is no short position cost that we must count with during the construction of the trading system (when using direct shorts of the ETF).

I have already described the strategy in this overview.

  • Direct short
  • Option strategies (naked call, long put, vertical spreads)
  • Pair Trading (Double Short)

 

Holding time

Here is very much about the concept and dynamics of the whole trade. It is true that shorter trades are rather speculative, they are benefiting from the expected reversal from the extreme price and fast backward movement. Long-term positions, on the contrary, usually have enough room to fully demonstrate the inefficiency of the ETF and the market therefore declines due to this inefficiency (eg due to strong contango on underlying futures, etc.)

Here is a simple division:

  • Short term> more speculative concepts – typically days to weeks
  • Long-term> More Conservative Path – Several months to units of years

 

Money management

Here, of course, it is important to set the maximum risk on a single trade and strictly following it. Again, the above mentioned- in the case of option strategies, risk control is far more simple and more flexible (I mean, of course, the covered strategies – or long term strategy).

Furthermore, the maximum risk for the market must be respected. It is true that we cannot allocate to the best trading opportunity, for example, 50% of the account. For one market, I am tolerating as maximum 10% potential loss (usually a mixture of long-term – majority, and short-term positions – minority).

 

Entry signal

There can be of course many entry signals for short. Perhaps the most frequent is, of course, the current positions of the underlying market (for example, if it is above the moving average or another indicator signalizing the overbought market according to the technical analysis).

But I personally prefer a model that takes into account the cause of the inefficiency – most frequently the contango and its current development (for example, for the ETFs linked to volatility it is the contango for futures contracts for the VIX index, for ETFs linked to the price of natural gas it is a contango on gas futures, etc.).

I also encountered approaches when some traders use for entering to the short positions the moment when the underlying futures market moves from backwardation to contango.

There can be many entry signals, we will describe several entry approaches in the following parts of the series.

 

Position-sizing

Here I do not mean increasing the number of positions in connection with the increasing amount on the trading account. Rather, it is about determining whether to enter a given market in a single trade or multiple times (dividing the trade into more tranches).

E.g. for entry to short position on volatility based VIX index, my model says there are several interesting and statistically significant levels – let’s say levels 20, 26 and 35 – that are suitable entering a short trade on volatile ETF / ETN (VXX, UVXY, …) .

My trading plan should therefore take into account whether I will open the tranches or not and how big the position will be in terms of the size of the account.

 

Exit from the trade

High quality exit strategy is, of course, essential for successful trading. In principle, we have several options – of course, depending on the type of instrument used for short trades (ETF or option).

  • Classic stop-loss (or securing though call option protection) – for a direct short ETF
  • Time stop-loss – I described it in the case of a pair shorting of the ETF (eg 1 year); in the case of options, I recommend to end the position min. several weeks or months (in the case of long-term positions) before expiration to avoid possible inconveniences in moving the price of the underlying asset against our trade very shortly before expiration.
  • Close based on the remaining option premium – typically for credit options / option spreads – if the position is in profit from 80%
  • Expiration – it is possible to leave expire the option as worthless, but the price of the underlying asset must be very distant (at least several tens of% – this is very individual and depends on the specific market and its volatility)
  • Rolling – In case of unfavorable development, it is also possible to move to position, typically in time, at a more distant strike and for the next period. Premium from the newly opened trade is usually equal to or higher than the currently closed option or option spread.

 

I will dedicate time to all the individual components of the trading system in other parts of this educative series.

 

 

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