Trading inverse ETFs and leveraged ETFs are becoming more and more popular with retail traders. Maybe it’s the appeal of quick profits with 2X and 3X leveraged securities like FAZ (Ultra Bear 3X Financials), but should we adjust our options strategy for these unique products? I think we should for good reason. While we don’t trade these often here as part of our income strategy, there are instances where they become useful and we’ll cover the specific setups in the show. Enjoy!
Key Points from Today's Show:
1. Remember that inverse/leveraged ETFs have pricing drag.
- If you are trading an inverse ETF like FAZ — which is a three times bearish inverse ETF on financials — they have what is called pricing drag.
- These inverse ETFs end up pricing lower because they are based on percentage changes, not necessarily tracking dollar changes.
- See episode number 27 to hear more about how ETFs are priced.
- See episode number 68 with Mark Sebastian about trading volatility.
If the index you are tracking is a 1:1 ratio, if the market goes up by 1%, this ETF is going to go down by 1%. However, if the market goes up by 1% and then goes down by 1%, it is theoretically back at the same level although it is a little bit higher because of the interest differential. The ETF that went down by 1% is now started in a lower level and is going to climb by 1%, it's not going to make up that difference between the ETF and the index.
*There is a growing disparity between what its price is and what it should be.
2. Use a shorter duration or trading period.
The pricing differential on ETFs starts to compound on top of itself.
The disparity between what it is actually trading and what the ETF price is, becomes greater.
With this increase in disparity, that means you are best served to keep your trading timeline really short.
Keeping the duration short allows you to take advantage of a quick move.
3. Inverse ETFs are mainly used for hedging.
- At Option Alpha we rarely trade any inverse ETS of leverage ETFs.
- It is really hard to do them, even in the direction that they are moving in.
- There will always be a negative pricing drag, so the market adjusts the options accordingly.
- These can be used to hedge your position, without needing a lot of contracts.
- With a double of 3X leveraged position, it is possible to get into small position to hedge another position.
*One of the only times that it can be highly profitable is when things like FAZ, VXX move against their overall trend of negative drag in pricing lower, that might be an opportunity to sell options on them or to go bearish on them because the long-term outlook is that the longer you hold them, you will take advantage of the pricing structure over the next 30 to 45 days. Trading VXX is one of the most profitable trades, however, it does not always go higher.