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Leveraged ETF Pair Shorting Strategies

Posted in Short Selling, Volatility Effects

“Shorting Leveraged ETF Pairs” looks at shorting leveraged long/short pairs of exchange-traded funds (ETF) and letting the short positions “melt away” over long holding periods. Findings suggest that the approach may be profitable, with most of the gain coming when market volatility is high. What about more active strategies of continually renewed short positions? To investigate, we consider monthly renewal of short positions in the ProShares Ultra S&P500 (SSO) / ProShares UltraShort S&P500 (SDS) 2X/-2X pair and the ProShares UltraPro S&P500 (UPRO)ProShares UltraPro Short S&P500 (SPXU) 3X/-3X pair. Using monthly adjusted closes for these ETFs and for the S&P 500 Volatility Index (VIX) from respective inceptions through June 2015, we find that:

The basic strategy is:

  • Take initially, and at the end of each month renew, a -$100,000 short position in each pair member. This strategy generates an initial $200,000 cash in the portfolio and subsequently adds to or subtracts from this cash monthly based on short position performance.
  • For a baseline analysis, assume return on cash covers any costs (transaction fees, bid/ask spread and interest on borrowed positions), but test sensitivity to net carrying cost.

An alternative strategy is:

  • Maintain the short positions only when the prior-month VIX close is above its pre-sample period monthly average. Otherwise, take no positions.
  • Assume a good estimate of VIX monthly close relative to average is feasible just before the close, allowing action on that estimate at the same close.

First, we consider the SSO/SDS pair, with the sample period beginning at the end of July 2006. The average monthly close of VIX prior to that time (January 1990 through June 2006) is 19.2.

The following chart shows the buildup of cash for the basic (Short Both) and alternative (Short Both + VIX Rule) strategies for the SSO/SDS pair over the available sample period. The VIX rule specifies shorting in 44% of months, avoiding an initial loss but missing some gains.

The average gross monthly gain for Short Both (Short Both + VIX Rule) is $737 ($666), with losses experienced in 35% (13%) of months. For both strategies, gains concentrate during the high-volatility financial crisis. In this regard, average monthly performance statistics are not very meaningful. What happens if the return on cash does not cover carrying costs?

short-SSO-SDS-pair-cumulative-value

The next chart summarizes sensitivities of net terminal values for the basic and alternative strategies for the SSO/SDS pair to monthly net carrying costs ranging from 0.0% to 0.5% (roughly 6.2% annually) of the short balance over the available sample period. The Short Both strategy is very sensitive to the level of carrying cost, with a negative terminal value when monthly carrying costs reach about 0.4%. The Short Both + VIX Rule alternative is more robust to carrying costs because it is idle about 56% of the time.

What about the 3X/-3X pair?

short-SSO-SDS-pair-terminal-value-carrying-cost-sensitivities

For the UPRO/SPXU pair, the sample period begins at the end of June 2009. The average monthly close of VIX prior to that time (January 1990 through May 2009) is 20.1.

The next chart shows the buildup of cash for the basic and alternative strategies for the UPRO/SPXU pair over the available sample period. The VIX rule specifies shorting in 33% of months, missing some gains, such that the terminal value for alternative strategy is much lower than that for the basic strategy.

The average gross monthly gain for Short Both (Short Both + VIX Rule) is $734 ($386), with losses experienced in 31% (13%) of months. However, for both strategies, gains concentrate in mid-2011. In this regard, average monthly performance statistics are again not very meaningful.

What happens if the return on cash does not cover carrying costs?

short-UPRO-SPXU-pair-cumulative-value

The final chart summarizes sensitivities of net terminal values for the basic and alternative strategies for the UPRO/SPXU pair to monthly net carrying costs ranging from 0.0% to 0.5% of the short balance over the available sample period. Again, the Short Both strategy is more sensitive to the level of carrying costs than the alternative strategy, with a negative terminal value when monthly carrying costs reach about 0.4%.

short-UPRO-SPXU-pair-terminal-value-carrying-cost-sensitivities

In summary, evidence from simple tests indicates that shorting pairs of leveraged long/short ETFs may be profitable, depending on costs of resetting/carrying the short positions, with most of the profits coming from short bursts of volatility in the underlying.

Return on investment depends on broker capital requirements (including margin calls).

Results suggest that, while these strategies do not consistently generate cash, they may be cost-effective hedges against an equity market crash.

Cautions regarding findings include:

  • The strategy may work better for ETF pairs that are even more volatile than UPRO/SPXU, but pair behaviors can be erratic (see “Multi-year Performance of Leveraged ETFs”). 
  • Some VIX rule threshold other than the pre-sample average may work better. A rule requiring that VIX be above its average for the prior 12 months (results not shown) does not work well. A threshold higher than the historical average may be able to capture the profit bursts during very short periods of exposure, but experimental optimization impounds data snooping bias.
  • Sample periods are not long in terms of number of market volatility regimes relevant to outcomes.
  • Leverage may amplify return distribution wildness, such that “normal” statistical measures lose meaning.
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