“When I first started to put out sell-side research in the early 1980’s, I believed that going short was simply the mirror image of going long. I assumed that all the attributes used on the long side could be reversed on the short side. I no longer believe that.” Jim Chanos
I’ve argued publicly against shorting no matter how tempting for a long time. The problem with shorting is that you have to get your timing perfect directionally. You have to be so spot on as to not miss a sharp decline, and not be whipsawed to death waiting for the big decline to occur.
Shorting, combined with daily leverage, is even worse. Not only do you have to get the timing right, but you have to know the daily path and volatility interaction to have a chance at making real money. Inverse funds are not just about direction, but also about the sequence of returns day to day that are being leveraged.
With all that said, let’s get into one of the fairly well-known inverse leveraged ETFs. The ProShares UltraPro Short Dow30 ETF (NYSEARCA:SDOW) seeks to deliver daily investment results that correspond to three times the inverse (-3x) of the daily performance of the Dow Jones Industrial Average®.
This ETF is not a traditional investment vehicle. It is a complex financial instrument that uses futures contracts and swap agreements to achieve its investment objective. While it can be an effective tool for hedging against market downturns or capitalizing on short-term market trends, it’s imperative to understand the inherent risks associated with leveraged inverse ETFs before trading them. And that is precisely why I’m against products like this for most traders.
The Mechanics of SDOW
As mentioned, SDOW achieves its investment objective by using financial instruments such as futures contracts and swap agreements. These instruments allow the ETF to profit from falling prices in the Dow Jones Industrial Average (DIA), thereby providing its inverse exposure. However, due to the daily reset of leverage, the performance of SDOW over longer periods may not align perfectly with three times the inverse of the DJIA’s performance. The daily reset of leverage can result in very different performance than one might expect, especially in highly volatile see-saw daily markets. Even if stocks ultimately go lower, the daily reset can lead to different results, especially when leverage is applied.
In August 2011, there was a 6-day span of a very volatile sequence which illustrates the pitfalls of daily leverage. Because of the extreme back and forth day after day, even though stocks closed positive, the 3x leveraged approach didn’t (on the long side). Now imagine how this dynamic applies on the short side.
The Risks Associated with SDOW
Investing in SDOW carries several inherent risks, including:
- Leverage Risk: The use of leverage can amplify gains, but can also magnify losses. If the DJIA rises significantly, SDOW could incur substantial losses.
- Compounding Risk: Due to the daily reset of leverage, the performance of SDOW over longer periods can deviate significantly from three times the inverse of the DJIA’s performance.
- Market Risk: Like all investments, SDOW is subject to market risk. If the overall market rises, SDOW will likely incur a loss.
- Credit Risk: SDOW uses swap agreements and futures contracts to achieve its investment goal. This exposes the ETF to the credit risk of its counterparties.
Investors must consider these risks carefully before deciding to invest in SDOW.
Key Considerations When Trading SDOW
When trading SDOW, there are several key considerations that investors should keep in mind:
- Market Volatility: SDOW is most effective in low volatility declining markets where the DJIA is experiencing gradual declines. In extreme volatility where stocks ultimately end lower, SDOW would perform in ways that many would consider unexpected because of the daily reset into see-sawing markets.
- Daily Monitoring: Given the daily reset of leverage and the potential for significant price swings, it’s crucial to monitor your SDOW holdings on a daily basis.
- Setting Clear Entry and Exit Targets: Due to the inherent risks and volatility of SDOW, it’s important to set clear entry and exit targets and stick to them.
I’m worried about a credit event. The path is likely going to be difficult for everyone, including those who might be seeing it coming. While SDOW can be an effective tool for short-term trading and hedging in the event a tail event does occur, as I suspect it likely will, I just don’t think it’s worth playing with fire. If you can trade it well, more power to you. This is a pass for me no matter how bearish I am because of how path volatility interacts with direction.
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