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The Risk of Shorting an ETF and Its Inverse

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Understanding how this trade might not work in your favor.

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A reader writes:

Watching the action in a dozen or so leveraged ETFs, it would seem the tracking error has attracted an arb-like play. Short both the ETF and its corresponding inverse, at days end make the tracking difference...more fun and games. My question is, if this is how money is made, should we all partake? And does it ever stop?


It sounds like it should work, right? I mean these pups almost all track one-day moves in the underlying index. Over the course of time, compounding math eats them up (it's not tracking error, they work as designed). The greater the leverage and the greater the "choppy" sort of volatility, the faster they underperform. So why not short both and then sit and wait?

Well, the truth is you can, but just know it's far from a riskless trade, it's somewhat similar to selling options gamma. If you sell a straddle in, say, IYF, and IYF closes near the strike you shorted, you win. But if IYF trends one direction, you lose.

Instead of that though, let's say you short FAS (3x the Russell Bank Index) and it's evil twin, FAZ (-3x) in equal dollar amounts. Let's say $100,000 of each. Now suppose the Bank Index rallies 3.33% today. FAS would rally 10%, thus you're short $110,000 worth, while FAZ declines 10%, making you the equivalent of long $90,000 of financials. So net-net, you're now suddenly short $60,000 worth of financials (the 20,000 difference x 3). And now tomorrow, the bank index again rallies 3.33%. Your FAS short now is up to $121,000, while your FAZ short declines to $81,000. You've lost $2000 on the combo (it's worth $202,000 combined) but you're now short the equivalent of $120,000 worth of financials ($40,000 x 3).

See where I'm going with this?

The compounding math will work in your favor if/when the financials reverse. But you have a risk trade on -- the risk being a trend in either direction.

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No positions in stocks mentioned.
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