December 17, 2014

Transition to volatility hedge hybrid

If you want the expected returns, you have to follow the system's rules.  This seems like a good time to take another step towards my longer term plan.   However, in this journey there has been a bump in the road I didn't foresee.  It seems almost silly now that I didn't. 

There's a huge advantage to low rate margin versus using a leveraged ETF.  It is based on the same principle of volatility decay.  VD (seems appropriate), will whittle down your returns as the underlying moves up and down.  When a leveraged ETF moves lower, it then has to move even higher back up.  On a relative basis, the ETF underperforms the underlying.

However, there are times in strong or longterm trends where these ETFs will strongly outperform for the same reasons.  The problem is, you don't want to be put into a position where it's impossible to regain losses.  With leveraged ETFs, this is possible even if you never sell.  They will still lock in gains, the lower they go.

For example.  Let's say over the period of one month, $SPY moves down 20% and you are invested in $SPXL.  It can and will happen.  $SPXL will likely move down about 50-60%.  If the move is in big enough bursts, you may very well believe your position has outperformed the market by a small amount.

If for some reason you are using stops and risk management, you would have gotten out by now and would be fine.  But if you are pursuing a static portfolio system like I am, you would still be invested.  Your investment of 100 dollars would now be valued at 50 dollars at best.  In order to recoup our losses, $SPXL now has to gain 100%.  $SPY only has to go up 25% to return to our original values.  When it does, $SPXL may go up as much as 80'ish percent.  However, you have now underperformed  $SPY by 15-25%. 

It gets worse the bigger the fall.  $SPXL could easily be down more than 90%, requiring the market to triple before you get back to even.  If you invested in the 2x leveraged $SPY, $SSO, then you would still be underperforming $SPY, even after 7 years.  $SPXL was not around at the time, or it likely would look much worse.

The lack of these products, particularly 3x long market ETFs, during the financial crisis, has given them a credibility as viable instruments that they don't deserve.  I don't believe we are headed towards another crisis yet, but you can never know that, and you can't invest on that belief.   Eventually horrible things will happen.  If all your money is in $SPXL when it does, then it's very likely your losses will be permanent.

There are some ways to counter this.  The first is having your eggs in many baskets.  I'm using a volatility hedge where I short both long and short volatility ETFs.  I have gold, bonds, and dollar.  Then I have some trending stocks and finally $SSO (as of today). 

The other way is to use stops.  You miss some gains this way, but it's the perfect partner for leverage, and you will likely consistently outperform the overall market if you stick to your system.

One last way is rebalancing or averaging in.   There's a philosophy in trading that averaging in is a poor strategy that will compound your losses.  I wouldn't recommend it in individual stocks, and I would limit it to small increments as the market lowers.  History of the S&P has shown this to be a very sound strategy.  Obviously the ability to do this requires having cash on hand or using non-correlated instruments that you are willing to sell when it's time. 

I will likely follow all three strategies at some point.  The latter two only when things are much more dire.  For today, I've opened shorts in volatility ETFs, lowered my dollar hedge, and switched $SPXL to $SSO.

For today, it looks possible that $SONC will be exited as $NKE was today.  $SONC almost reached 30% gain before this most recent decline, and part of me wants it to survive to someday see that number. 


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