Hope to hear from you.
Jan

I haven’t made any kind of objective analysis on how far to let it go. I started in July 2009 as the market was rising. So my long ETFs got bigger than my short ETFs. I was okay letting it go until 65-35 or even 70-30 because it formed a sort of hedge against the rest of my normal long portfolio.

On the other hand if the market gone down and the short ETFs got too big, I would probably rebalance sooner.

I can see someone using a reasonable rule that they rebalance if the long ETF grows to 70-30 or if the short ETF grows to 60-40. That would make sense if the rest of your portfolio is long.

The other aspect of rebalancing is whether to rebalance back to 50-50, or something short of 50-50. I favor the latter because I don’t want to miss out when the underlying reverts to the mean, which is the very essence of the strategy. For example, suppose I get to 70-30 and I want to rebalance. I short only enough of the 30% to bring me to 60-40, rather than going all the way to 50-50.

If you use options to implement the strategy, per previous comments in this thread, you can avoid the question of rebalancing all together. More precisely you postpone the question until you roll forward your options, at which time you have to choose whether you do 50-50 again, or roll forward the “out of balance-ness” from the previous month. I hope that makes sense.

Good luck!

You mentioned the following:

“There is more to the strategy, particularly 1) how to best implement it using options and juicing up the return by collecting some option premium in the process, 2) rebalancing when it gets too far out of whack, and 3) how to minimize risk in conjunction with the rest of your portfolio. I’ll leave the first two points alone for now. ”

I’m interested in point 2 of the above. How much does the price of either of FAS or FAZ have to rise by before you will rebalance? Assuming I start off with an equal position size for each of FAZ and FAS (i.e. a 50-50 ratio), I was wondering if I should start rebalancing once I hit a 55-45 ratio or allow for more room, perhaps a 60-40 ratio. Grateful if you could share your experiences on this point. Thanks!

You want to write both pairs enough ITM that both will be exercised. Otherwise, when the price of one side drops below your strike price, you’re no longer making any money on that side. But of course you’re continuing to lose money on the other side as the price rises. As a result you choose options with delta close to one and you don’t get to collect as much premium, but you still get a little. Psychologically I love the idea of collecting premium every month.

I have had to take protective action on a few occasions but not as much as you’d think. Even during the run up last half of 2009 for the most part I found there was sufficient volatility to keep both sides within shouting distance of each other and make the stategy profitable despite the rising price of the long ETF.

I experimented with near months and far months. I haven’t attempted to calculate with much rigor which is best. The nice thing about near months is you get a “do over” on a strike price every month. Going out several months or using LEAPS is more dangerous because there is enough time for the price of one side to drop below your strike. This is probably reason enough to use exclusively the closest month, or go out at most two months if your commissions are high. Another reason is that the further out you go, the options have priced in an expectation that the price of the underlying will decrease. This is less true of the near month. As long as you keep writing new options every month, you are getting the benefit of the long-term decrease in the underlying without paying a lot of premium for it (or, equivalently, without losing quite so much of the premium that you would otherwise be collecing).

More recently I have been using bear credit spreads (your number 2). As you suggested, you can use puts to do the same thing (your number 3). Put-call parity means they should be equivalent.

It is hard to collect much premium this way. Usually you end up paying premium, unless your OTM call is high. Which of course increases the risk. I design my strikes so that the maximum I can lose on one side is roughly counterbalanced by a gain on the other side. As a result I don’t like my OTM call to be too high. It’s impossible (I think) to turn it into a no-lose strategy, but you can limit your losses to very reasonable amounts this way.

Numbers 2 and 3 have one other important advantage over naked calls or shorting the ETF directly. The margin requirement typically is much lower (depending on how wide your spread). That means I can do much more.

Your number 1 (shorting ETF and buying protective calls) has the same problems as simply shorting the ETF, with the exception that you have some protection in a one-way market. You still have to worry about hard to borrow fees, distributions, and buy-ins.

With your number 4 (OTM puts) you’re right you won’t make much if you transact at the edges of the spread. If you are able to buy at the midpoint, you could make it profitable. Myself, I would be hesitant to try unless my broker had technology that allowed me to place a combo order (e.g. I choose a limit price for the combo rather than for each side, and either I get both sides or neither). If you try to put one side in place and then the other, you may find yourself with one side in place and trying to get the second side in place but unable to get a price at which the strategy can be profitable.

Note that number 4 and number 3 are qualitatively the same. The only difference is one has a higher strike price than the other for one put.

Let me know if you have any follow up thoughts.

Is it OK for you to share a little about using options to implement this strategy?
I can think of couple of ways but figure out they are not easy to get profitable.
1) Short ETF pair and buy calls to protect. Problem: out-of-money calls are so expensive.
2) Buy out-of-money calls and short in-the-money calls to form a bear credit spread. Idea: Time premium collected from the short side should be equal to cover the time premium on the long side (for normal stocks). Problem: out-of-money calls have far more expensive time premiums than in-the-money calls for these leveraged ETFs.
3) Buy in-the-money puts and short out-of-money puts to form a bear debit spread. Problem: Similar to the problem of calls, in-the-money puts have far more expensive time premiums than out-of-money puts.
4) Buy and short out-of-money puts to form a bear debit spread. Problem: Such a spread costs a lot! Sometime it could be more than the spread itself.
Example:
Bid Ask
FAZ120121P00012000 4.65 4.80
FAZ120121P00013000 5.20 5.75

To creat a bear spead, you have to spend 5.75-4.65 > 1

Your opinion will be highly appreciated!

I’ve been using the strategy for one year, since July 2009. Like the author, it has done nothing less than revolutionize the way I invest. I have had extremely positive results.

Several comments were asking for some implementation details. I’ll put a few thoughts down based on my own experience.

I started with a wide variety of pairs, about 20, but cut back to 8 pairs. I no longer do 2x funds. 3x funds work better (which I knew going in but wanted to see for myself). Also, an underlying with higher volatility is better. That has led me to use mostly FAS/FAZ and TNA/TZA, with a smaller amount of DPK/DZK, CZM/CZI, EDC/EDZ, ERX/ERY, LBJ/LHB, and MWJ/MWN.

At first I was shorting each ETF pair. It was working fairly well. I was up about 3.5% in 4 months. However I was paying all kinds of “hard to borrow” fees, which as you might guess is the fee you pay to borrow and short ETFs that are hard to borrow. With most of the ETFs I pay between 2% and 6% but at times it got to 10% or higher. CZM was 25% for a couple days in June. But most stay in the 3-5% range (annualized percentages). I have heard that the cost can go way up with most brokers however. I am at IB. I have the sense that they are much more fair to their customers.

There are also “dividends in lieu” which is the dividend I have to pay when the fund has a distribution. Paying out dividends isn’t necessarily bad because the share price drops by a roughly equivalent amount. But it can be bad from a tax perspective. It is essentially trading an investment expense for a capital gain, which can do unexpected things to your taxes (either harmful or helpful depending on your tax situation) which is beyond the scope of this comment. Anyone who wants to implement the strategy, I would urge you to spend some time to understand how you will be taxed.

After four months I started using options to implement the strategy, thinking I would avoid both the “hard to borrow” fees and the big distributions. I have also found that my broker is a little easier on my margin with options, which means I can do more. And trust me I do more. I’m so excited about the strategy that I use every last bit of margin available.

The last 8 months I’ve been using a combination of options and shorting the ETF. Options have been much better. They have been more profitable, I am able to limit my losses (which is important in a runaway market, as the author importantly pointed out), and they are WAY more fun.

Oh, I almost forgot one other benefit. Options can’t be called back. I have had several buybacks (that’s when the broker can’t borrow the shares and closes your position). Buybacks are bad because it leaves one side uncovered, but also because your broker buys back at whatever price the market is offering. That is bad when the spreads are wide. Most of the ETFs that seem to get called back are more thinly traded, meaning wide spreads. With options there is no buyback risk.

There is more to the strategy, particularly 1) how to best implement it using options and juicing up the return by collecting some option premium in the process, 2) rebalancing when it gets too far out of whack, and 3) how to minimize risk in conjunction with the rest of your portfolio. I’ll leave the first two points alone for now. On the third point, for the most part the rest of my portfolio is a “typical” diversified long-term portfolio. I like the idea of hedging it a little. As a result I tend to short slightly more FAS than FAZ.

I’m up 16% so far, inclusive of all commissions, shorting fees, dividends in lieu, etc. That’s 16% in one year. 16% in one year people! The rest of my portfolio is up over 30% over the same timeframe, but that’s not the point. I would be up the same 16% if the market had been a mirror image of itself and the rest of my portfolio was down 30%. Therein lies the real power of the strategy. It performs the same way regardless of which side of the mirror you’re on.

I track the results daily so I can run some statistical analysis. For those that like portfolio statistics, you may be interested to know that the strategy (as I have implemented it – big caveat) has a beta of -0.20 and a DAILY standard deviation of 0.73% (compared to the market portfolio of beta = 1 and st.dev. = 1.21% over the same time period). In other words, the volatiliy is MUCH lower than the market, and the negative beta means it does an incredibly efficient job of lowering volatility in conjunction with a typical long portfolio. Over longer periods of time I would suspect the beta to approach zero.

And here’s the real kicker. Alpha = 18.2%. There is not a hedge fund in the world that I would trust to get me alpha = 18.2% with significantly lower volatility than the market and negative beta.

Granted this is only over a 12 month period. But there are a couple reasons to believe the numbers will only get better. First, the strategy does well in volatility and less well in one-way movement. The first 6 months (July 2009 to Jan 2010) had nearly one-way movement up, and yet the strategy did okay. In a more volatile or sideways market it will do better. Second, I can implement the strategy much better now than when I started, which means my returns should get better. And like the author mentioned in one of his posts, the real icing on the cake is that the strategy would have made 16% even if the market had been a mirror image of itself. That’s powerful.