profiting from decay in 3X funds

S

stevenpaul

Hi,

At the risk of beating a dead horse, as this subject has clearly been covered at length in this forum and elsewhere, I wanted to run a strategy by you all. It has been suggested that the very sort of statistical decay responsible for the skewed performance of FAS during the initial phase of the recent bull run can actually be used for safe profit-making by shorting both FAS and FAZ. The trade is effectively hedged in the short term, and over time profit is won through the effects of volatility-based decay. That trade would have failed miserably, of course, due to the extreme bull move we are currently enjoying. FAS took off and FAZ's decline's couldn't compensate for it. The decay was certainly not enough to offset the losses owing to trendiness. Trend works against the strategy and volatility favors it.

Contrastingly, I'm wondering what might happen if we short just one 3X pair. For example, we go short X $ of TNA and go long 3X $ of IWM. I imagine the IWM position would keep up pretty well with the TNA position even in trendy times, but when volatility sets in, IWM should return to starting position sooner than TNA. That's when profit can be seized. This is just an instinctive idea and I haven't run any figures. What are your initial impressions?

Thanks.
 
Quote from stevenpaul:

Hi,

At the risk of beating a dead horse, as this subject has clearly been covered at length in this forum and elsewhere, I wanted to run a strategy by you all. It has been suggested that the very sort of statistical decay responsible for the skewed performance of FAS during the initial phase of the recent bull run can actually be used for safe profit-making by shorting both FAS and FAZ. The trade is effectively hedged in the short term, and over time profit is won through the effects of volatility-based decay. That trade would have failed miserably, of course, due to the extreme bull move we are currently enjoying. FAS took off and FAZ's decline's couldn't compensate for it. The decay was certainly not enough to offset the losses owing to trendiness. Trend works against the strategy and volatility favors it.

Contrastingly, I'm wondering what might happen if we short just one 3X pair. For example, we go short X $ of TNA and go long 3X $ of IWM. I imagine the IWM position would keep up pretty well with the TNA position even in trendy times, but when volatility sets in, IWM should return to starting position sooner than TNA. That's when profit can be seized. This is just an instinctive idea and I haven't run any figures. What are your initial impressions?

Thanks.
More...

Didn't you "backtest" it ? :D
 
Quote from stevenpaul:
----statistical decay responsible for the skewed performance of FAS......
----profit is won through the effects of volatility-based decay.
----That trade would have failed miserably, of course, due to the extreme bull move we are currently enjoying.
----losses owing to trendiness.
----Trend works against the strategy and volatility favors it.
----What are your initial impressions?

Thanks.
More...
1) Are all of those leveraged ETF's "hard to borrow" to initiate short-sales?
2) You would want the ETF to be stuck in a trading range in order to benefit from the "decay/re-set".
3) You'll be hurt in a strongly trending environment, i.e., the leverage will hurt you.
4) There was a good article in the March-2010 of Futures Magazine that properly describes the "decay".
5) Impressions?......has the "opportunity" already been arbed to death? :cool:
 
No, I haven't backtested it further. Its not terribly hard, I just had that handy. Trading can get slow at my office during the day so I did it when I had some down time.
 
There is 100% certanty that there is price decay and shorting both in equal amounts will result in a profit - if you hang on long enough.

There is also almost 100% certanty that you will get called out of your short at the worst possible time.
 
Quote from stevenpaul:



Contrastingly, I'm wondering what might happen if we short just one 3X pair. For example, we go short X $ of TNA and go long 3X $ of IWM. What are your initial impressions?

Thanks.
More...

My impression is that it would be alot more mangeable and less absolute risk using the x3 on one side only, and on a r/r basis would be comparable to going x3 on both sides
 
Quote from akeserla:

Just changed the Dec 41 2008 dates to use the last price. So this analysis will hold for good.

http://spreadsheets.google.com/ccc?key=tmZ7nFxW2lKlOoJ8VVvWasw
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Backtesting for an idea like this is problematic at best. This is an interesting idea, but I am not sold.

We are discussing a low reward, high risk, high % bet. The expected return of the leveraged etf stays the same as the volatility of the underlying goes higher, while the median return goes lower. This implies a different distribution of returns, not a lower expected return. That means if the stars align properly, your double and ultra ETF can really take off higher (particularly the double and triple shorts). These double and triple short ETF's can easily go hard to borrow at the same time, just like SKF did back in March 2009. First I would trade this strategy using strict stop losses. I would also suggest buying an upside call to help hedge the trend risk. However, the teeny calls in the leveraged etf's are juiced up due to this very phenomenon. This would naturally somewhat eliminate the "decay" returns you are after.
 
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