Tuesday, March 24, 2009

Decay

Many people are aware of the decay of highly leveraged ETF's, however they may not realize the magnitude of the erosion that they may face if they hold for a long time.

Lets take a look at the date the FAS and the FAZ started, November 6, 2008.


  
Symbol 11/6/2008 3/4/2009 Change Expected Change
RFIN.X $703.19 $491.76 -30.06% -
FAZ$74.41 $21.15 -71.57% +90.18%
FAS$49.15 $6.12 -87.54% -90.18%






Hmm... That's interesting. They are both down a massive amount, with the FAZ down a smaller amount due to its bear nature. But, look at the discrepancy between where one might expect FAZ to be and where it actually is. The term expected is used extremely loosely to show what an investor might mistakenly believe to be his return (300% of the index change, over any length of time).

There have been approximately 110 trading days since the fund's inception.
Therefore, on average, the daily and annualized losses (based on the past 110 days) is as follows:

Symbol 110 DAYS DAILY ANNUALIZED False Earnings Potential Loss(Gain) Due
To Decay as compared to investor's
expected value
RFIN.X-30.06% -.32565% -30.14879% -
FAZ-71.57% -1.26566% -91.261234% 161.75%
FAS-87.54% -2.10448% -96.349879% (2.64)

Note that in fact the daily magnitude for both funds have far surpassed three times that of the RFIN in either direction.

You might ask why I say the loss is 161.75%, as you can't lose more than all of your money. You are correct. What it means is that the mistaken investor would have expected FAZ @ 141, and it is actually at 21. The difference of 161.75% is based on the inception price. (Expected 141 - 21 = 120/74.41 = 161%).

The point is, don't hold these things too long. They are merely day trading and swing trading instruments that can eat away at your capital


This 'phenomenon' is exploitable....

So, if you had sold short $5,000 worth of FAZ and $5,000 worth of FAS on 11/06/2008,
and covered today, your portfolio would be worth $17,950. An incredible 59% return. The problem here is capital. You couldn't pull this strategy off without an incredible amount of capital behind you--or the blessing of a sideways market, in which the ETF just compounds itself to nothing on a daily basis.

If one of the stocks went in one direction too harsh, and too close to your purchase date, a margin call from your broker would destroy your position. See 11/20/2008 where FAZ hit $201.86, +172%. FAS hit $14.65 -70%.

But, as time increases outward from your purchase date, the possibility of this happening becomes extremely small because of the decay itself. (as t->inf. , risk lim->0)

Now look at this strategy:

Lets say you held 1.5x cash reserves in your account to protect yourself from a forced short cover by your broker. So your initial portfolio was $25,000 and you only invested the $10,000. Obviously your cash balance is $15,000, which would cover your short position even at the most extreme point (historically of course). With $7,950 profit, your return would be 31.8% (over 110 days). A little bit less, but more of a realistic strategy.

Of course, you have to worry about actually getting the shares short for such a long period of time. Probably not possible to pull this off. Put maybe.




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