OK, so long as Inverse options remain all the rage, how about a quick refresher course?
The popular Double Ultra’s and Double Inverse Ultra’s track the daily percentage move of an underlying ETF. And then reset the next morning and track it again. And so on.
But over this course of time, this math does them all in, both the longs and the shorts. It’s the same principle as if you run a fund that goes down 10%, and then back up 10%. Net-net you’ve lost 1%.
Consider some hypothetical ETF, we’ll call it IYF and its composed of a group of financial companies (let’s call them IBM and GE and GM). Let’s say it trades at 100. And we list an Ultra ETF that goes up double the daily move in IYF (we’ll call it UYG). And let’s say also we list an Evil Twin called SKF that moves twice the inverse of the move in IYF. And both UYG and SKF trade for 100.
Now on Day 1, IWF goes up 2% to 102. Assuming the fund manager tracks perfectly to design, UYG would rally to 104 and SKF would decline to 96. Now let’s say on Day 2, IYF goes back down to 100, down 1.96% on the day, but unch. over 2 days. UYG would decline double that percent, back to 99.92, while SKF would rally double the percent to 99.76.
Yada yada yada, every time the underlying ETF revisits a price, all “trackers” will have a lower NAV than they did the last time the index was there.
Is there an arb?
Eh, not really. The reason is that technically you would need to adjust your position to keep dollar neutral. Consider the real UYG and SKF, As financials declined, you needed to keep shorting more and more shares of UYG to keep flat. Plus shorting both has other risks, like the new shorting rules that may have kept SKF way above NAV without clarification.
So bottom line is that even in a world where Ben and Hank let you short things, there’s better ways to make money than this. But I would just also that this constant overhang of math makes long term ownership a poor idea. They’re really designed for swing or day trading in my humble opinion.
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yes, the slippage is criminal … definitely NOT long term vehicles
thx
yup, zactly.
Thanks a lot, Adam. Your illustration makes the point crystal clear even to me!
Adam,
I just got off the phone with the Skiffles people and they are hopping mad.
They resent this whole “evil twin” characterization thing, and respectfully request that in all future blog posts you refer to them as “Vindicators of the Golden Financials” or if you are posting on Danny’s site: “Bones, Thugz & Banks.”
Adam, on a more serious note… I wonder if this slippage is exploitable with regard to their unusually high call premiums?
It strikes me that the calls are always incredible expensive on these things (and especially Skiffles, hence my regular sales against my holdings) despite the NAV erosion that seem endemic to their profile.
Is it possible that’s some kind of market glitch that can be exploited?
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smiper: thanks
Jake: Don’t forget the skew is backwards because it’s an inverse. Meaning, the higher the strike in sKF, the higher the volatility generally speaking. That being said, I do like the idea. I’ve also tried short UYG vs. short SKF calls worked ok, not great. Of course now they’d arrest you on the spot for that, lol.
The drift is and isn’t exploitable. It’s similar to being short gamma though, if let’s say you go short both uyg and skf, and iyf goes lower. You’d have to short more uyg to stay “neutral”, or just take your chances that a move reverses, so there is some risk to it.
SHORT GAMMA MAKE HULK MAAAAAAAADDDD!!!
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Big brain Adam talk make Hulk head hurt. Adam stop or Hulk “SMASH!”
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