Inverse ETFs vs. LEAPS puts

Inverse ETFs are best used for trading, rather than to buy and hold for the duration of a bear market. Non-traders looking to hedge their longs or profit from the bear market should consider long-term put options instead. Contrary to popular belief, options can require less expertise and offer a lower overall risk to a portfolio than short ETFs.

Brutal math

The main problem with short ETFs is that as the underlying indexes get lower, small dollar moves become large percentages, especially in 2X funds. This math works against you as the market exhibits volatility on its way down. A dollar of loss in an index wins you a smaller gain in your short fund than a dollar of gain in the index from that lower level gives you a loss in your fund.  Here’s an illustration:

Imagine if XLF (a financial index ETF) goes from 20 to 19 one day, and SKF (SKF’s 2X inverse) goes from 100 to 110.

$1 out of $20 is 5%, so SKF goes up 10%

$1 down = $10 up

The next day XLF goes from 19 to 20, so SKF goes to $98.42 . $1 out of $19 is 5.26%, so SKF goes down $11.58.

XLF is back where it started, but SKF is down 1.42%.

As many have learned in the bounce from the July 15 lows, this math can be brutal with larger percentage swings, and these moves will only get wilder as the market goes lower.

LEAPS are lower risk than short ETFs (in smaller quantities)

If you are very confident about financials or REITs or the broad market going lower and are not a proven trader, use LEAPS (Long Term Equity Anticipation Securities), long-dated options. The whole idea behind the existence of an options market is to decrease risk. Make the concept work for you.

You can buy January 2010 puts on XLF, IYR, SPY, IWM, QQQQ, whatever you want, and just sit tight. 2011 LEAPs are being rolled out, and December 2010s are available on SPY. Don’t trade in and out if you aren’t a pro. Those blistering rallies on the way down won’t change the fantastic percentage gains that await if you have the longer trend right.

So many people risk big chunks of money in double short ETFs, and then screw it all up through bad trading, when they could just put a fraction of the money into LEAPS puts and get out of their own way, with the ultimate dollar gains being the same in the end. The balance saved can be kept safe in treasury bills, and those could be a lifesaver if things get really hairy and the markets are compromised. This strategy offers lower risk than inverse ETFs without sacrificing potential gains.

LEAPS may also offer reduced counterparty risk due to the rules of the options market, as opposed to whatever wizardry the investment banks use to make those funds do what they do.

FAQ: How high can inverse ETFs go?

For the record, the theoretical gains in any short ETF are unlimited. You can always go down another 1% or 10% or 50%, no matter how low an index goes, so a short ETF can keep going up by the same (or double) percentages forever. The catch is that volatility and the math explained above will keep things down to earth.

Don’t dismiss cash. It’s in a bull market.

I am not recommending shorting to anyone. Only you can decide what may be appropriate, and the key to getting through the next few years will just be to come out with your capital intact. That will be heoric enough.

9 thoughts on “Inverse ETFs vs. LEAPS puts

  1. Your excellent article mentioned the following:

    “The balance saved can be kept safe in treasury bills (of foreign governments if you like), and those could be a lifesaver if things get really hairy and the markets are compromised. ”

    How do you invest in the treasuries of foreign governments?


  2. Well, if you are using a plain-vanilla US broker, it may be tough to buy them directly, but you could go through a mutual fund like MERKX. However, the dollar seems to have finally turned, and foreign bonds are tanking relative to US treasuries, with the exception of Yen-denominated bonds. But then, Yen bonds are extremely low yield, so you can just hold Yen cash.

    If you have a broker with broad international market access, buying foreign Treasuries should be no problem. Unfortunately, I can’t recommend one for a US-based individual. Maybe Peter Schiff’s Euro Pacific can do it. They specialize in foreign stocks.

    But US Treasuries are ideal right now. Don’t be afraid of the dollar anymore.

  3. Agree completely about trading the short and ultrashort ETFs. On stock boards you still see questions from knuckleheads who just don’t get it.

  4. I own a whole range. It really depends on how far I think the underlying security will fall within the time frame and how high the option premium is.

    Before the crash, I would look at something like IYR and say to myself that it could go to 20 (from say 70) by Jan 2010. I’d look at the various strikes and see that if it did fall to 20 I’d get say 6x my money with 50-strike puts and maybe 15x with 30-strike puts. Of course, with the 30s, you have the risk that it only falls to 30 and your puts expire worthless. I was pretty certain that the 50s would be in the money by expiry, so there is a risk-reward balance here and your risk-preference will determine which you favor. I

    That’s about it. Every security is unique. I have bought in the money puts and super deep out of the money ones. These days, with option premiums so high, I’m not buying much, since it is hard to see very many of these returning better than 2-3x the premium.

    A year ago, I was putting a lot of my money into puts, so I would typically not try for home runs, since I wanted to minimize the risk of losing a big chunk of my net worth. I used to look for 4-5x in just a 30% fall in the underlying. Those are now in the money, and I’ve sold a bunch of them and am letting the rest ride so that taxes are pushed into ’09 or because I think they have a little juice left in them. I wouldn’t be buying most of them today.

    I’d wait for a really big rally before buying again. I’d want the VIX under 40 and the Dow up 25-30% from its lows before shorting again. Then I’d go out as far as possible on expirations and look at deep out of the money puts.

  5. Mike,

    Thanks for the info on LEAPS strike prices. Very helpful.

    If my stats are correct, the low in the DOW lately was about 8,175. It has risen about 14% to 9,325. It’s reaching toward the 25-30% you mention, but it still has quite a ways to go this time around.

  6. Good advice. I did not know about the LEAPS. I made quite a bit of money on proshares SDS. I was sweating bullets, not so much on the volatility but the fear of counterparty risk. Have you hear of the direxion 3x leverage. Crazy shit. Marc Faber recently pointed out the Nikkei is back to 1981 levels, the korean index is at 1988 levels. If the S&P goes back to 1990 levels, it would be at 300. There is more money to be made on shorting the indexes my friend. Question is how high will this bear market rally.

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