Fas faz pair trading using options
This post documents some of my research in creating a trading strategy centered around shorting leveraged exchange-traded funds ETFs. I present the following thought experiment to motivate readers:. These two securities are analogous to the two securities in the thought experiment.
SPY, the underlying security, has remained fairly unchanged but with moderate volatility over this time period. In addition, this trading strategy is exposed to low risk because shorting this pair of securities is market neutral. The remainder of this post is organized as follows: Section 3 describes exactly how to execute this trading strategy.
Section 4 recommends specific leveraged ETF pairs. Section 5 describes the risks to this strategy. Section 6 contains links to further resources. ETFs track the price of its holdings by trading extremely close to the net asset value of its holdings throughout the trading day. When the price difference between the net asset value of an ETF share and the underlying basket of securities gets too large, authorized participants can either purchase or redeem shares.
Leveraged exchange-traded funds are a special type of ETFs that are designed to be more sensitive to daily fas faz pair trading using options movements than non-leveraged ETFs. The hedge fund I previously worked at could be described as a fundamental global macro fund. Also suppose that this leveraged ETF will trade for two days. What are the four potential outcomes for this leveraged ETF?
Below I plot a histogram that displays the ending price of 10, simulated leveraged ETFs identical to the hypothetical example except that they trade for a period of 1, days instead of 2. This histogram shows exactly why leveraged ETFs are not to be held for long periods of time — the price decay has a significant effect that pulls the most likely outcome towards zero.
It shows why things like the Kelly criterion exist. The alpha in this trading strategy stems from the impact that volatility has on cumulative returns. It is important to re-balance because having an unbalanced notional amount exposes you to either a long or short bias on the underlying. This trading strategy does not have a fas faz pair trading using options on the future direction of the underlying in fact we are hoping that the underlying remains at a similar price but with high volatility around this priceso you should not be exposed to this bias.
Selecting leveraged ETF pairs to short should be done based on three criteria: The ideal leveraged ETF pair would be a pair of ETFs with a low fee rate, high number of shortable shares, and high future volatility. Below is a screenshot containing some of the leveraged ETFs that I considered. This section contains recommended links to additional resources that contain discussion about shorting leveraged ETFs:. The code underlying this post can be viewed at my Github fas faz pair trading using options.
If you are interested, please fas faz pair trading using options your email below. Have you tried this out? Would be curious how it has gone. At first I thought you might have actually used market returns of indices and leveraged them. I already shared this link in an off-topic comment on your latest bitcoin post, but other folks have done actual market-based simulations to show that leveraged ETFs generally perform well over long periods of time. Not 2x or 3x as well as their indices, but generally better than their indices and not dwindling inevitably to zero!
Leveraged inverse ETFs, however, may go towards zero over time—I will investigate that one. Should be a pretty easy tweak to my model to find out, actually…. OK, that did not take long.
In my 30 year simulation of inverse leveraged ETFs using real data from Yahoo! TMV -3x long term treasuries: Thanks for your comment. Interactive Brokers automatically bought in some of my positions, even though I was trading in small size. So I decided to stop using this strategy. Thank you for sharing those links and your research about leveraged ETFs. A sharpe optimized portfolio over the last 30 years would be quite heavy in long term treasuries but of course that data set starts around the beginning of the great bond bull market.
Rebalancing is critical to bank the volatility gains—these portfolios require more frequent rebalancing than most to get optimal results about 8 rebalances a year works well. Can we optimize based on historical data what percentage would be the perfect percentage to rebalance? Or also maybe put in some kind of rule that would automatically rebalance after say 1 month, regardless of the percentage difference.
Would we increase the short balance of the smaller investment i. This would effectively have us keep increasing our exposure on the table, even though we are technically market neutral. I really want to implement this to see how it goes.
Any suggestions on how to do this? You may be able to modify their code and implement a grid search where you iterate over a reasonable set of criteria and find out what works best. Ideally, you would want to repeat this process over multiple leveraged ETF pairs. Backtesting this strategy is kind of hard though because your results vary wildly depending on exactly what day you start the strategy. So your backtest would ideally randomize the start date instead of starting on some arbitrary day.
If you want to actually use this strategy, I actually recommend using options now instead of using the underlying. I tried trading this strategy on my personal account, but my broker bought in one leg of my short position without warning before I could profit. Fas faz pair trading using options that not happened I would be up by quite a bit though. Then again, the best performing mutual fund in used this strategy see link belowso who knows.
One could conceivably write long-dated calls or buy in-the-money puts also long-dated and take advantage of this. Your post is very timely though! I was just about to write something related to leveraged ETF decay. Buying puts is definitely a valid strategy and professional investors have used this strategy to great effect.
Take a look at this news article for inspiration: It would be interesting to explore how this strategy would fit into a portfolio. For example, does the return pattern correlated with certain systematic factors?
Is it possible to characterize the environment in which the drawdowns occur and relate that to drawdowns in other strategies? Nick de Peyster http: Drawdowns will occur when the market trends in one direction, either positive or negative.
The strategy performs best in highly volatile but trendless markets. Thank you for continuing to read and comment on my posts, I really appreciate it.
In a world with lots of superstars, you write one of my favorite financial blogs. Great to have you posting again.
What am I missing? Thank you for the kind words. The idea behind shorting both the long 3x and the short 3x leveraged ETFs is that you are market neutral until the two sides become unbalancedand if you rebalance at the correct times, you can remain market neutral.
But I have heard of professional investors fas faz pair trading using options money using this strategy. I present the following thought experiment to motivate readers: Short the same notional amount of both ETFs. This means fas faz pair trading using options if the long and short ETFs have different prices, calculate the number of shares to short of fas faz pair trading using options such that you are short the same dollar amount amount of each. As prices change, the notional amount that you are short each ETF will begin to be unbalanced.
Re-balance periodically by fas faz pair trading using options short fas faz pair trading using options covering the proper ETF to bring the notional amount into balance. Cover both shorts to exit the trade after sufficient time has passed. Despite what the initial charts suggest, there is no arbitrage opportunity. Returning to the hypothetical example in Section 2, while the most likely outcome is for leveraged ETFs to be drawn towards zero, there are outcomes in which the leveraged ETF increases significantly in price.
This means that there is the risk for extreme loss. Extending the hypothetical example to being short a pair of leveraged ETFs does not eliminate this risk — sustained moves in either direction without much volatility lead to extreme loss.
The returns to this strategy are similar to several options-related strategies that are designed fas faz pair trading using options generate a small positive return with high probability but a large negative return with low probability.
In addition, as with any short-selling strategy, maximum losses are unbounded. The position is not market neutral. Although this strategy involves shorting equal notional amounts of leveraged ETF pairs with periodic re-balancing, this strategy is not truly market neutral.
In between re-balancings, the notional amount of each leg will become unequal and necessarily expose you to either a long bias or short bias on the underlying. Drawdowns can be significant. Be prepared for the potential of large drawdowns. Since this strategy relies on going short on margin, your account must contain sufficient funds to maintain your position. This strategy relies on re-balancing periodically which incurs additional transaction fees.
Costs to borrow the fee rate are a function of how hard it is for your broker to locate shares to short and can fluctuate over time. Further Resources This section contains recommended links to additional resources that contain discussion about shorting leveraged ETFs: Shorting Leverage plots some equity curves for common leveraged ETF pairs.
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