Quote from arizonadreamer:
If a double short ETF underperforms, wouldn't a strategy of shorting x shares of the short etf and 2x shares of the "underlying" be profitable?
For example, sell short 100 SDS / sell short 200 SPY.
AZD
Arizona - don't let 666 confuse you. Your strategy is spot on, not only is it spot on but it happens all the time. One of the neat things about ETFs is that there is a built in arbitrage system within the primary market. ETFs are issued in Creation Units â blocks of shares that are essentially sold to a market maker. The block of shares (50k = CU in my experience) represent an underlying âbasketâ of stocks. Only in the primary market â a market maker can purchase Creation Units (blocks of shares) either âin kindâ by trading the basket of stocks or with cash.
The ETFs I have experience with track Russell indices. If you look at BGU (R1k bull) for example you will find that the firm has âoptimizedâ the basket of stocks from 1000 down to roughly 400 stocks. A lead market maker can purchase a CU (50k shares) either by paying cash (50k x NAV) or by turning in an appropriately waited basket of 400 stocks.
Every ETF has two tickers because there are two values, the ETF has a ticker BGU and the underlying basket of stocks has a value (and a ticker BGU.IV). Tomorrow, take time to watch the iNAV and the NAV of several ETFs. Youâll find that there are many arbitrage opportunities however they usually donât last for very long. Another great thing about ETFs is that they can be created or redeemed at will by the LMM to keep up with demand. Sometimes, you will find that market action will force the NAV to deviate from the iNAV â causing the shares to trade at a premium or discount from their underlying value, this is exactly what you suggested in your quote above. The Primary market for ETFs has a built in system where LMMs can create or redeem shares (long or short) in cash, or in kind so that they can arb the shares back in line with the securities they represent.
For example, if an ETF was trading at a premium (NAV at $50 when the underlying basket was worth $45) the lead market makers in the Primary market would go out on the street and buy the basket of stocks (valued at $45) and trade them in to the fund for 50k shares ($45*50k=$2.25mm⦠50k shares @ $50 = $2.5M, or a $250k profit). We see many âblack boxâ or program traders constantly monitor the iNAV vs. the NAV and take an opportunity to go long/short a given ETF knowing that it will be seconds or minutes until a Lead Market Maker arbs it back into place.
As a side note â you will probably find that the best time of day to take advantage of this is right at the close, hold overnight and look for the correction at the open.
Hope that sheds a little lightâ¦
EDIT: little bit of a long winded answer and I realize that I didn't really speak to "underperformance" - watch the NAV vs the iNAV for a few days and look for the correction at the following open, I have no experience with 2x, only 3x... but in my experience with leverage etfs its usually market action at the close that causes the issues
