Stock Market Student

Last post I produced some nice graphs for the situation when x3 leveraged long and short ETFs are held at the same time.  With monthly rebalance, all of the ETF pairs investigated declined in value over time.  So now I wish to start work on a speculative "system" that shorts both the bullish and bearish ETFs at the same time.   NOTE:  Please don't confuse shorting an ETF with buying a short (bearish) ETF.  By shorting an ETF I mean borrowing shares of an ETF for the purpose of selling short.

First thing to do is surf the web for similar strategies.  As it turns out I am not the first person to think of this strategy.  Here is an interesting description of this strategy already being tested with some success:  http://www.darwinsfinance.com/short-etf-inverse-leveraged-direxion-3x/

Note the risks identified on the website above:

Not Enough Shares to Short with Broker

Margin Call

Margin Costs

Runaway Market

Addressing these issues one at a time:

Not enough shares:  Select only the most liquid ETFs i.e. highest $volume traded ETFs

Margin call:  Active position management including regular rebalancing of positions.  Selection of multiple markets which are (hopefully) not too correlated.

Margin costs:  Some brokers don't want to be bothered or want to be compensated for their effort involved with finding and borrowing shares.  Shop for a broker with small interest rate charges.

Runaway market:  Rebalancing strategy should consider how far a market has moved, not just a specific time interval.

Here are some more concerns:

Volatility:  Market volatility has been exceptionally high the last couple of years.  Low volatility may lead to losses.  Due diligence is required i.e. long term testing before jumping in.  There may also be a need to switch markets / ETFs based on predicted future volatility (if it is possible to predict).

Dividends:  Borrowed shares have to be returned at dividend time (I believe).  Thus it will be necessary to have advance notice of dividend payouts and close the positions prior to then re-open them after the dividends have been payed.

Next post I'll make a selection of leveraged ETFs for study.

Thanks for reading.

Steve

So what happens when one buys both long and short leveraged ETFs at the same time?  Let's find out.  Below are some buy and hold examples.  (Sorry about the plain Jane graphs).  Equal $ value of long and short ETFs are bought and held.  The left axis is total dollar value normalized to $100 at start.  The bottom axis is months held.

So the results look OK but not spectacular.  Now let's see what happens when the holdings are rebalanced at the end of each month.

 Not too shabby!!!  These graphs show fairly smooth degradation almost every month for every instrument examined.  This is great but not a trading system (yet).

We still have to figure out how to trade this phenomenon and diversify the holdings.  But that will have to wait until next time.