The time has arrived to finally unveil Darwin’s Inverse Leveraged Short ETF Strategy. If you’re wondering what it is and why it matters, in a nutshell, it has completely changed the face of trading for me – and it can for you too, if you have the access to the 2X or 3X Leveraged Funds required, if you enable margin trading, if you have the capital requirements and if you can monitor and sustain risk of loss. It’s a long name, and it can be complex to follow so please read along.
What is Darwin’s Inverse Leveraged Short ETF Strategy?
I will start at the most basic level and delve into increasing levels of complexity as we go. At it’s most basic level, you short opposing leveraged ETFs at the same time with equal funds. The desired outcome is a market-neutral strategy whereby you can reap significant returns over time regardless of what equities at large are doing. What wealthy investors pay a hedge fund manager 2% plus 20% of profits is now at your fingertips – with risks, that you must understand and manage. Take a look at the chart below for an example from 2009. I’ve charted the performance of the 3X short ETF, 3X Long ETF and the underlying sector ETF all related to the Financial Sector.
Note how the Blue Line (XLF – 1X Financials ETF) is up marginally over the period. Meanwhile, FAS, the 3X Leveraged Financial ETF is down close to 50% while FAZ, the 3X Short Financials ETF is down over 90%. If you shorted both FAS and FAZ for calendar year 2009, you made 50% on FAS and 90%+ on FAZ for a normalized gain of 70%. You made this 70% during one of the most tumultuous, volatile and desperate trading years in our generation. And get this – you’re not really putting up the funds to earn that 70% (sort of). You can be long in whatever you want (cash, stocks, bonds, whatever) and use your short capability to dedicate a portion of your portfolio to daul inverse short ETF positions as I outline below.
Wait, if one Leveraged ETF is up, the Inverse ETF must be down, right?
Nope – More often than not, they’re both down over long periods of time (just months, we’re not talking years here). That’s the tragedy (for long investors) and the beauty (for shorts). Due to daily rebalancing, which slowly erodes the value of these ETFs, everyone’s screaming from the rooftops that they’re bad buy and hold investments. In fact, there are numerous lawsuits against Direxion and Proshares for selling these “instruments of mass destruction” to retail investors – and even professional money managers – who can’t grasp the concept. Basically, if you’re going to take a number and go up 2%, down 2% bouncing back and forth, as long it’s not a steady march in one direction for weeks on end, both sides will decline over time. Try it out yourself in a spreadsheet – you’ll see – it’s that simple. Since they are such bad investments over time, rather than diving in head first and buying them; short them!
Darwin’s Actual Returns: Inverse Leveraged Short ETF Strategy
So as to remove any doubt, I’ve included the actual screenshot of my trading account as of this weekend where Ameritrade clearly outlines my total gains and losses since opening the position. In each of the pairs (ERX) (ERY) Energy, (FAS) (FAZ) Financials and (GLL) (UGL) Gold, I’m up. Note how the NET gain for each pair is positive – that’s the key. I’m up regardless of what happened to the underlying sectors. In order to understand what these returns would look like on an annualized basis, I’ve performed some nifty excel functions since I’ve only been in each position for a few months. I also made sure to include the impact of short dividend sales and distributions that occurred late last year (which makes my return look worse, not better).
Double Digit Returns – Nice!
You might be saying “So what? The S&P500 is up 65% since the bottom in March. And you’re wasting time making 37%?“ That would come from someone that’s totally missing the point. The market will not be up 65% again in the foreseeable future. The market will undergo corrections and lackluster years. This model is blissfully indifferent to the whims of the overall market returns. This model can also make 37% when the market is down. It can make 37% when the market is flat. By using sectors that aren’t correlated closely (oil, gold, financials), and offsetting the time of entry, I’m even introducing diversification into the returns of each pair.
Remember Madoff? People Lost Their Life Savings Chasing 12% in Any Market.
Well, this is as transparent as it gets and you can capture double digit gains annually in any market – as long as you manage and understand your risks as outlined below. I will continue to share my specific short trades and results here (Subscribe).
Sounds Too Good to be True – What’s the Catch?
There’s an important factor I didn’t share yet – and I want to highlight it prominently. This model breaks down when the underlying sector takes off. There are margin issues to consider. There are several risks and considerations – please read the next section before trying this.
Risks and Considerations
I already have a disclaimer on my blog, but I want to reiterate that fact that I am not certified to provide financial advice. I am an individual trader and not your adviser. If you want to embark on a risky strategy that entails margin requirements, the ability to cover margin calls, the ability to sustain losses in the event of unforeseen market moves, and other risks that may not have been outlined here, you should consult your own adviser before doing so. I think you get the point. Aside from that, I want to highlight where this model breaks down and how I personally manage risk in my leveraged short portfolio:
- Not Enough Shares to Short with Broker: I ran into this with my TMF/TMV Short Pair as evidenced in the performance snapshot. Basically, Ameritrade called up one day and said I had to close out my short position because there weren’t enough shares to short. This was a few months into the position and in looking back to 7/1/09, if I still held those shares short, I’d be up an impressive 19% on average since they each lost 19% over that ~6 month period coincidentally (see Short Treasury Pairs Chart Below). That was one of those circumstances where each side of the trade lost a substantial amount of money over a brief period. Anyway, there’s really nothing you can do to prevent this from happening other than going with a larger online broker and going with the more prominent pairs. What I’ve found is that multiple pairs I’ve tried to short with multiple online brokers have not been available to short. So, I’ve had to settle with the 3 pairs I have going now.
- Margin Call – Given the recent more stringent margin requirements for leveraged ETFs (which really did nothing to address the lack of understanding of these instruments and only made it more expensive to trade), it’s entirely plausible that when one of the pairs may have gained by say, 50% (meaning you’re 50% in the hole in a short position), even though it’s inverse ETF pair may have lost, say, 70% (meaning you have a 70% gain there, for a net 20% positive position), the customer service rep likely won’t even understand the math involved and quote procedure and say that you’ve either gotta pony up more capital or close out your short position. While this would still net you a gain overall in this hypothetical scenario, you may be margin called in a sub-optimal situation or have no extra cash to input.
- Margin Costs – Depending on what sort of other capital and holdings you have in your portfolio, be careful that you’re not paying exorbitant margin fees to maintain this strategy. While I’m not getting hit with margin expenses because these positions aren’t occupying a majority of my portfolio, if you have this strategy eating up the max margin window, you may be paying 10%+ in margin fees to maintain a strategy that may not even make 10% for you ex-expenses.
- Runaway Market - This is pretty much your largest risk. While I outlined how you can make money on both sides of the inverse leveraged ETF pairs in many situations, when an underlying index appreciates (or depreciates) so rapidly on a routine daily basis without a significant break in the trend, you can literally have runaway returns. Remember how you can say, make 40% on one side and lose 32% on the other side and still come out ahead? Well, what happens when a leveraged ETF returns over 100% in a given period? You can’t make more than 100% by shorting anything – it’s mathematically impossible. What would actually happen is your gain would be maxed out at around 90% while the runaway leveraged ETF could be up say, 200% (net loss of 110%). Recall, when you short something, your losses are infinite. See below on how I manage a Runaway Market. To demonstrate an extremely bad situation, see below (Bad Chart) for what happened from the absolute pivot bottom in March until September in 2009. FAS was up over 500% ! This would have killed an investor who stayed in short without taking evasive action.
How to React to a Runaway Leveraged Short ETF Situation
What do you do if you undertook the strategy when an underlying index takes off, delivering triple digit gains on one side of the coin? There are a few options at your disposal, none of them being optimal.
First, you could run for cover and just close your positions. You’d take a loss, which happens in trading. I’d advise against just closing your losing position and letting the other one run since it’s no different than just opening a 1-sided short position now, which is more akin to just picking a direction and shorting it as opposed to the market-neutral returns the Inverse Leveraged Short ETF Strategy is supposed to deliver.
The next strategy, which is what I’ve modeled out and started to do for one position when it ran involves offsetting risk of further loss and seeking a new market-neutral overlay position with stock options. It’s rather complex, and up front, one can’t possibly line out how every scenario must be confronted on a generic level. Much depends on which underlying index you’re dealing with, what volatility looks like, how far out of whack the inverse ETFs are, etc. This will be the subject of Part 2 (subscribe for free for future posts) of this series on Darwin’s Inverse Leveraged Short ETF Strategy. In short, you reset the equation with options (either puts or calls, writing or buying [depends on the situation]) such that if the dual short ETF strategy runs away on you, your are compensated by the overlaid options position(s). The bottom line is you’ve gotta be prepared for another run up or down because this runaway scenario can and does occur.
How Does This Strategy Fit Into My Portfolio?
As I alluded to earlier, there are now pretty rigid margin restrictions and lack of available shares to short out there, so you can’t go willy-nilly shorting all kinds of pairs without collateral to back it up. In my case, these short positions occupy a portion of a broader trading portfolio that includes long stock positions, options, credit spreads, and other strategies. As such, a failure of any one or two inverse short ETF pairs wouldn’t be devastating, nor would it trigger margin costs that I couldn’t readily rectify. I just want to make it clear that you can’t go open a trading account funded with $2,000 and go short $2,000 in ETF pairs. If you’re considering this, consider how it fits into your broader portfolio, if at all.
Why Am I Telling the World About This Strategy?
I’m not the only smart guy out there who’s figured it out. And I’m not that smart – the traders at Goldman and the quant funds are smart. There are probably crazy blocks of trades going on exploiting this stuff on a daily basis with all kinds of derivatives, options and futures supplementing these strategies. Think of this as the poor man’s hedge fund. As such, it’s only a matter of time before it’s out there, so why not be the first to publicize and share what I’m doing? I wanted to allow several months of tested data to show that I was putting my money where my mouth is, and it’s looking good at this point. Might wider adoption result in fewer shares to short, impacting my ability to continue to do this into the future? Maybe, but there will likely be an ample supply of uninformed retail investors continuing to flood into long positions in leveraged ETFs despite my best attempts to highlight Leveraged ETF Risks of value decay over time.
Short Treasury Pairs Chart
This is what a good chart looks like – when both sides of the Leveraged ETF Pair lose value over a short period of time. Just let it ride!
Here’s What a BAD Chart would Look Like:
When this happens, you can’t sit idly by and watch your margin short position take off. Back at the 50% up mark on FAS, I would have taken evasive action as outlined above.
Check out the tickers in the lists below, plot them side by side in Yahoo!Finance or Google Finance charts and move the slider around. You’ll find some cases where this worked out beautifully and some where you could be caught with a losing position. The trick is to find the right pairs and manage the position closely by checking at least once per week.
- Full Leveraged ETF List for your reference.
- If you need ETF Tickers for general sectors, here are over 800 ETF Tickers by Description.
This post will surely result in some discussion and questions.
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