For those of you who are risk takers, speculators, or just looking to make a quick buck, this next strategy may be for you. Going back to a previous strategy where we were utilizing leveraged ETFs to achieve greater diversification and less risk, we are now going to use those leveraged ETFs to massively leverage our portfolio.
As of February 8, 2007, the S&P 500 is currently trading at 1444 and its index tracking stock the SPY is currently trading at 144.60. The market for the month of February has been on a tear and my belief is that we are about to experience a short-term pull back. There are two types of ETFs, there are Ultra-short, which go up 2% for every 1% loss in the S&P and there are Ultra-Long, which go up 2% for every 1% gain in the S&P.
To idea of this strategy is if we are bearish on the market, we will buy the Ultra-short and sell the Ultra-long, giving us a 4x leveraged position without buying on margin. The opposite should be done for a bullish market sentiment. For this example, I will use the Bearish strategy and explain the possible outcomes.
We will go long the Ultra-Short S&P ETF
We will go short the Ultra-Long S&P ETF
I will be going long $145,000 of the Ultra-Short ETF
I will be going short $145,000 of the Ultra-Long ETF
We are now trading at 4x the market movements, so for every 1% drop in the S&P our ETF holdings will increase 4% and vice versa,
Here are some potential outcomes with account starting value at $145,000:
The S&P 500 drops 5% in a month:
ETF holdings will be worth: $174,000
Total Account Value: $174,000 for a total profit of $29,000 or a return of 20.00%
For a month of holding this position we have an annualized return of 240%
If the S&P 500 goes against us and rises 5% this is how the portfolio will look:
ETF holdings will be worth: $116,000
Total Account Value: $116,000 for a total loss of $29,000 or a loss of 20.00%
This strategy while very risky, can magnify returns and could be utilized by small individual investors that want to trade at the day trade leverage of 4x, without meeting the requirements and being exposed to margin interest, because of the canceling out long and short position.
An interesting approach may be to identify two standard deviations from the price at the beginning of the month and place a buy at the lower end of the range and a short at the top of the range, this should encompass 95% of the total possible returns of the month. If a trader takes into account statistics in their trading, a strategy that leverages 4x can magnify the returns. Even if the opportunity to enter this trade presented itself just once a year, it is still can be a market beating strategy. If the market goes to three standard deviations then you can encompass 99.7% of the total market movements.
The leveraged ETFs while stating that they perform at 2x the daily movements may at times underperform or overperform that benchmark due to the value of the derivatives used to create the positions in the ETF.
Similar results can be acheived through options which your risk would be limited to the premium you paid for the call option. However, this initially puts you at a loss and creates a higher breakeven price than if you had just use the above strategy. Most likely if the market was approaching two or three standard deviations from the average then it would be possible to get contrarian options for relatively cheap.
Taxes and commissions were not taken into account during this example.
