Tuesday, December 23, 2008
Monday, December 22, 2008
Posted from Santos, S.P., Brazil.
The Shocked Investor is currently in Brazil and will return in early January. Several interesting news on the Brazilian economy will be posted soon. Amazingly, some sectors of the economy are still booming here.
Thursday, December 11, 2008
Ultra (2X) long or short ETFs have proliferated in recent years, and several have appeared in recent months, including 3X funds. There are now ETFs that give you double exposure on pretty much any segment of the market: gold miners and bullion, oil, financials, S&P500, Dow, etc.
These ultra ETFs are great if the market goes up or down and has no volatility in terms of ups and down days. In fact, theoretically, you'd make money buy buying both the long and the short ETFs as a paired trade. The reason is very simple. If you invest say $10,000 in both a long and short ETF, and the underlying index goes up by 1% every day for 10 days, the long version will be worth $x and the short ETF holdings will be worth $. In total, you'd have $x for your investment of $20,000. This is because your wins compound and get bigger and bigger, and your losses get smaller and smaller. After 1 day you have earned and lost $200 on each of the ETFs. On the 2nd day, however, you gain $204 on the long ETF but you only lose $96 on the short ETF. The gain is larger because it is now applied on a larger principal ($10,20), and the loss is smaller because it is applied on a smaller principal ($98,00). And so on.
The same thing happens if the market only drops, in this case, the short ETFs keeps getting exponentially bigger and bigger. Here are some of the initial points:
After 60 days you would have a total of $35,203.00, a gain of 76% over the initial $20,000.00 invested.
This charts shows what would happens in this scenario:
Clearly, taking a position on both the long and the short ERTF pays off, regardless of market direction. It is in a sense a timeless straddle. The only loss is due to MER, but there are also gains due to dividends and interests earned on the various derivatives used to achieve the 2X returns.
Now, what happens however, if there is great volatility, and the market goes up and down. Take a look at this extreme scenario, where the market goes up 1% one day, then down 1% the next, and then alternate doing this for 60 days.
At the end of 60 days you would have a total of $19,769.99, a small loss of 1.15%. Here is the chart, you can barely see the decline:
But is this what happens in practice? In the vast majority of cases, no. In fact, for the long run, it's almost guaranteed that this will not happen and capital will be lost. I wrote a piece of software that analyzes all these funds. It has ran over millions of data points.
Here are the various performances of the paired ETFs:
(please click on chart to enlarge)
The ETF issuers claim that this poor performance is due to daily resets and compounding. Daily resets are necessary so that the exposure of each fund remains at 2X or 3X on both the long and short side. This is not the issue, after each day the performance should still track 2X or 3X the underlying index. Compounding does have an effect if the fund keeps oscillating up and down every day, but, as seen above, this effect is small and nowhere near the large losses seen in practice.
WINNING LONG TERM STRATEGY
Based on the data and performance, a probable winning strategy with these ETFs is to short the pair of ETFs: short both the long and the short ETF. If you had done this with all the above ETFs, not counting the gains of DTO and DXO, you would have gained an average of 18%.
DTO and DXO are too new and have been on a trending environment (oil declining). It is likely only a matter of time until its performance degrades, just like all the others.
These ETFs are great for trading in and out if you get the market direction right, just as placing bets on red and black are at a Casino roulette is.
Just like a casino, you know what happens when someone keeps playing for a long time. The house always wins.
Charts of paired trades since inception (please click on images to enlarge):
You can see that SDS managed a gain of about 36%, while SSO had a very big loss of around 63%.
Tuesday, December 9, 2008
Two weeks ago week natural gas inventories showed an injection of 12 Bcf. This may have been, or is very close to, the last injection of the season. This was followed last week by a drop of 66Bcf. So it appears that inventories have started to decline for the heating season. Historically, prices will rise as the winter progresses.
Natural gas prices have seen a significant collapse after the oil bubble burst in recent months. With the NorthAmerican economy in recession, oil and gas consumption will be smaller than normal.
Natural gas is a potentially very attractive way to park your money. Instead of using money market funds, which in theory are safe (but we know are not now), natural gas offers the possibility of achieving higher returns in a shorter time frame. This can be done when prices rise (winter) or decline (spring, summer), by taking advantage of the ETFs such as UNG, HNU.to and HND.to (which are 2X leveraged).
Chart of inventories (storage):
(please click on image to enlarge)
Latest Storage data:
Price of UNG ETF:
The chart shows that last year the cycle low was in December 2007.
Chart of HNU.to (2X natural gas ETF):
Nothing on the stock market is without risk. One of the risks wit natural gas is if oil drops to $25. Natural gas may drop further, but in the long run, this is a very safe play as gas in the $5s forces companies in North America to shut production down, thus causing the price direction to reverse.
UNG was trading today around US$ 23.00 and HNU traded around CAD$5.00 (approx. USD$4).
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