Co-produced with Trapping Value

We are pleased to bring to you Part 3 of this series where we get deeper into the weeds with more complex hedging options. As previously mentioned, please note that not every choice will work for every investor. In fact, we are certain that some of these are way beyond the abilities of most junior investors. We are still presenting them to reach those who can use them and also to introduce them to fledgling investors so they can begin understanding them.

In today’s article, we will visit three strategies related to inverse funds and explain how they can enhance your hedging powers. We also will go into where these might be better than some of the ideas we have highlighted in Part 1 and Part 2 of this series. While we are presenting these ideas, please do note that we always will discuss general features of such funds below. There may be specific characteristics of certain inverse funds that might be very different. Investors need to do their due diligence of specific funds before placing trades.

Hedge 7: Going Long 1X Inverse ETFs

– Complexity Level 3

Many investors hate the idea of shorting stocks. They see “the sky is the limit” concept on the upside and want to detach themselves from that risk. Another reason they don’t short stocks is because they cannot. Most investors hold a good chunk of their assets in retirement accounts and shorting is forbidden in those types of accounts. While the first risk is only a real risk when you short substantial amounts of single stocks, and does not really apply to using small amounts of index shorts as hedges, the second is a very valid and legitimate concern. As investors approach retirement, sometimes as much as 75% of their assets are in IRA type accounts, and if you cannot deploy hedging strategies there, you are forced to be incredibly creative and do counter-productive things elsewhere.

This problem was solved by the person who first came up with the concept of inverse funds. In an inverse fund you can short the index by going long the ETF. This changed the margin concept completely as your worst-case scenario is the loss of the capital you put into the fund, unlike shorting funds. They also solve the other problem (ineligibility of shorting in retirement accounts) and these can be held inside an IRA. These funds have some interesting other advantages as well including rather low expenses and listed options on most of them. This allows investors to do covered calls on these funds, which reduces the volatility. For investors interested in seeing a parallel to this strategy see Hedge 5 in our earlier article.

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There has been an explosion in inverse funds since first introduced and they have expanded to over 150, covering asset classes across the board. Popular products here are ProShares Short QQQ (PSQ), Direxion Daily S&P 500 Bear 1X (SPDN) and ProShares Short S&P 500 (SH). The key disadvantage is the effect of compounding on these funds which causes decay. As these funds are set up to replicate the inverse of daily moves, whenever you hold them overnight you introduce a compounding effect. We can see this by observing the performance of going long SH vs. shorting SPY. From Jan 1, 2020, to March 23, 2020, you can see going long SH outperformed going short SPY. That’s compounding at work.

ChartHowever, year to date, going long SH has underperformed shorting SPY by a decent margin. That’s also compounding at work.

ChartWhile this is a concern over medium time frames, it’s not such a big concern over shorter time frames. We did think bringing it to your attention was necessary.

More Background on Decay

Before we address this one, we will address the concept of decay which applies to both sets of inverse ETFs. Take an example of two investors, one who shorts $100,000 of SPY shares at $300/share and another who buys $100,000 of SH at $25/share. To make our example more lucid, we will take extreme moves to illustrate it. This is what happens next.

Day 1: The markets move up 10% on news the Fed is buying stocks. SPY goes to $330. SH goes to $22.50.

Day 2: The markets move down 10% on news the Fed meant that it was actually buying storks. SPY goes to $297. SH Goes to $24.75.

https://static.seekingalpha.com/uploads/2020/7/5/47392447-15939721110044408.png

Notice what has happened here. The investor with a short position in SPY is up 1% whereas the investor that is long SH is down 1%. The reason for the latter is SH has less short exposure to the market as the market goes up. The portfolio went from $100,000 to $90,000 to $99,000. Inverse funds keep decreasing your short exposure as the markets go higher and keep increasing it as the markets go lower.

Hedge 8: Going Long Leveraged Inverse ETFs

– Complexity Level 6

Leveraged inverse ETFs dial up the heat and the danger levels of inverse funds. They have the same setup, except that they try and create a daily beta that is 2X or even 3X that of the underlying index. The result is incredibly magnified returns when you get the direction correct but with an extraordinary background decay. So, for example, between Feb. 24 to March 23, Direxion Daily S&P 500 Bear 3X Shares (SPXS) amplified the move of shorting the SPY shares.

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ChartBut over longer time frames the decay is very apparent. We have chosen a time frame below which best illustrates this. SPY shares were essentially flat between the beginning of the year and June 9. SPXS lost a whopping 44.98% in the same time frame.

ChartIt goes without saying that 2X funds will have less decay than 3X funds.

One fact that investors need to understand is that the decay also makes these funds less and less effective hedges over time. So an investor who used this for a 10% hedge on Jan. 1, 2020, now has a far smaller hedge in place on his portfolio.

Hedge 9: Shorting Leveraged Long Funds

– Complexity Level 8

Investors might have noticed the singular issue with inverse funds. They decay. Leveraged funds decay faster than your teeth would if you brushed nightly with Nutella. The optimist sees an opportunity in every problem and there’s certainly some opportunity here – but for very advanced traders and investors. We are talking about creating a hedge by shorting leveraged long funds. The idea here is that the decay works for you rather than against you.

We need to illustrate this as well and we will put all these tactics into one snapshot below. Here are the year to date performances of the ETFs listed alongside Direxion Daily S&P 500 Bull 3X ETF (SPXL) fund, which we are adding as our target for this strategy.

ChartShorting SPY, going long SH or SPXS, all would be money losers for the year. The only strategy that would actually have made money here would be shorting SPXL. Below we show the returns for a hypothetical $100,000 short hedge and returns on that hedge year to date.

https://static.seekingalpha.com/uploads/2020/7/4/47392447-15938684382058089.png

Even though the S&P 500 (‘SPY‘) index is almost flat year to date, shorting SPXL delivers tremendous returns thanks to the decay from the volatility.

So why does everyone not short by going short the long leveraged funds? That’s a great question and we are glad you asked that! Whenever anything in finance (or in life) looks too good to be true, it pays to ask why. There are several problems with this strategy and we are dead serious about the complexity level of this being an extreme “8.”

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There are many key issues here. First these shares are much harder to short and not available all the time. Even if they were available, they may be called at inopportune times forcing your short to be ended when you least want it to be.

Second, these shares do sometimes come with higher borrowing costs and these can run far more than 3X the cost of borrowing SPY.

Third, timing is extremely critical with these. If you shorted at the exact bottom, you did far worse than three times a SPY short.

Chart

Conclusion

As we feast into the more advanced menu of hedging, investors are cautioned that each product is unique even though many may be lumped together into a category. Investors must understand the underlying instruments and all risks associated with such products. The more exotic it looks and sounds, the more likely something unexpected may go wrong, unless you are a very experienced investor. Personally, the only hedge I have been using lately is shorting the S&P 500 index (SPY), which is a fairly simple hedge, and this is the only hedge we have been recommending to our investment community.

At the same time, having a buffet of all these hedging choices will allow you as an investor to fully understand how hedging works. It also will allow them to use a plethora of sentiment indicators including inverse fund asset changes and volumes. In the next part we will look at volatility indices and how they can be used to hedge a portfolio.

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Disclosure: I am/we are short SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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