Friday, November 21, 2008

If I could Ultra Ultra Short Financials, I would be RICH!!!

Let’s say you saw the credit crisis coming, and wanted to short the financials.

You see two different securities that you are interested, XLF and SKF. XLF is an index that covers many of the financial companies, and SKF is an index designed to give twice the inverse return of XLF. You think about shorting XLF, but you want more return for your future predicting powers, so you buy SKF instead expecting to get double the performance. Over three months, which return is better?

Shorting XLF.


The chart above shows XLF vs. SKF over a three month period ending Nov 14, 2008.

This is the problem with the new world of leveraged ETFs. The profile states “The investment seeks daily investment results, before fees and expenses, which correspond to twice the inverse of the daily performance of the Dow Jones U.S. Financials index.” But what it does not say is that it is only accurate at certain times. Looking at the chart, it seems that huge moves short for XLF were accurately captured by SKF (Oct 4 – Oct 10), but long moves by XLF proved to be overcompensated to the downside by SKF (i.e. Oct 10 – Oct 15 and Oct 23 – Nov 3).

Moreover, over time, for reasons not explicit to the end user, the SKF index does not continue to hold the NAV over time. Thus instead of getting the inverse result, the investor only gets the inverse result “for a short duration of time” before the index falls apart again on a bear (XLF bull move) move and waits for the next XLF short surge.

For a retail investor like myself, this is disheartening. I am not sure that I have ever seen the disclaimer for this poor correlation in the index. At least their should be some standard of correlation or grading system that should be applied to all indexes that use leveraging techniques.

On the other hand, better to just keep playing than crying about the rules of the game. In any case, I plan to use this information to my advantage. As of Nov 22, SKF is now trading at $280 after one of the biggest drops in NYSE history. Will it continue? Well, even if this is the onset of the Greater Depression, the XLF index can only go to zero folks. And the market NEVER goes straight down. Thus a purchase of SKF puts based on the observations mentioned here will most definitely yield a large return as the index swap agreements are rolled over and the bounce commenses.

Transparency: The author bought JAN 09 $80 SKF PUTS at $2.4 / contract and similar positions at similar strikes and prices and closed the JAN 09 $80 SKF puts at an average of $2.85 yielding a 19% gain.

5 comments:

myinvestorsplace said...

In thinking about which sector would be hardest hit, it seemed that the financials were about to really take it on the chin.

MyInvestorsPlace - trading, value, investing, forex, stock, market, technical, analysis, systems

Lockstep said...

Transparency: Closed half the contracts at $3/contract.

As expected, the security lost value from $290 peak to $140 in about four days. Unfortunately, the puts purchased were too out of the money to retain any beta value. So although the value peaked at $5/contract, it quickly deflated. Thus I thought it would be better to close half and wait for the next big run up to initiate the position again.

Mr. Padedoh said...

Wow, great blog
I too am a short seller, trying to profit from the great missteps.
Would like your input on the BoA-Merrill deal

Outcome #1 - Proceeds as usual
1. Increase in price of MER as risk arbs bid it up to get the spread
2. Decrease in BoA as risk arbs short BoA
3. Decrease in BoA as sudden deluge of sell orders (convert 1 MER to 0.8xx of BAC and sell)
4. Eventual decrease in MER and BAC

Outcome #2- BoA says no
1. MER collapses to 3.xx, a new deal is initiated with the Fed acting as the backstop

My take
- Short MER
- Short BAC
buy the calls on BAC at 12.50 Jan Expiration

Wenger J Khairy
Padedoh-In-Chief

Lockstep said...

The Merrill Lynch deal was a horrible case of acquisition-itis by Mr Lewis. There is an old saying "it is hard to change a players game in the 9th inning". Ken Lewis has built BofA for 20+ years through acquisition and integration, and has been successful. But it is obvious he performed no quantified due diligence when he pitched his offer to Merrill Lynch. Buying something with an unknown downside is a big no-no. This is why I have closed my BAC preferred positions as of December 24th. I am also still holding my BAC short positions.

PENNY STOCK INVESTMENTS said...

I can do without financials.