Guest Post: Fun With Inverse ETFs

Tyler Durden's picture

Submitted by Alexander Gloy of Lighthouse Capital Management

Fun With Inverse ETFs

I love Exchange Traded Funds (ETF). In theory. In practice they are being abused by issuers and traders alike (see Beware of systemic risk in ETF). But that’s another topic. Today let’s take a look what can happen with inverse ETF through the compounding effect.

I like inverse ETF (i.e. SH) on the stock market, because if I am
wrong (market goes up), my problem gets smaller (ETF goes down). If I
had sold short the market (i.e. SPY or via futures) my problem would get

Of course this “advantage” comes at a certain cost in form of a
potential performance drag. To make it clear, let’s look at 4 simple

Example A: Index drops 10%, then fully recovers on day 2 (+11.11%).
The inverse ETF however ends ups on a level 2.22% lower than on day one.
Why? The increase on day 1 is 10 points (or 10%), but the decrease on
day 2 (11.11%) is 12.22 points in absolute terms, since the percentage
drop is calculated based on a higher base (11.11% of 110 = 12.22).

Example B: Index rises 10%, then retraces fully on day 2 (-9.09%).
The inverse ETF drops 10%, then recovers 9.09%. The ETF ends up 1.82%
lower. Why? The %-increase is calculated on a lower basis (90), yielding
only an 8.18 point (9.09% of 90) increase on day 2.

Example C and D look at identical percentage changes with opposite
direction. In example C, the index first drops, then recovers (example D
the opposite). In both cases, the ETF and the index end up having the
same percentage changes from day 1 to day 3.

Conclusion: In a sideways market, the inverse ETF will have
performance drag. For levered (twice, triple) ETF the effect will be

The levered ETF (i.e. SDS) has another disadvantage: it even has
performance drag in a sideways market if the daily ups and downs are
identical in percentage terms. Here, we let the S&P 500 decline 1%,
then go up 1%, etc. for 460 days:

Over the course of 2 years (approximately) SPX and SH perform similar, while SDS underperforms.

Now let’s do same with 5% down, followed by 5% up days:

levered inverse ETF gets atomized (-90%). While investors in levered
ETF wish for high volatility in the short term (provided they got the
direction right) it clearly hurts them in the longer term.

Now, let’s look at a sideways market in absolute terms: 2% down, 2.04% up the following day:

The numbers speak for themselves; SH and SDS both suffer badly.

But now let’s say the S&P 500 index goes to 400, as some people
(including myself) believe (a normalization of corporate profit margins
and a 10 times earnings multiple almost gets you there without a
stretch). The market does it by declining 1%, followed by a 0.5%
increase the following day:

Compound growth starts showing up. Why? Theoretically, the index can
decline 1% each day for an infinite amount of time (even at SPX 400 it
can go down another percent).

And what would happen if this 1% down, 0.5% up pattern goes on for 5 years?

who had bought just one SDS would be multi-millionaire! Of course, with
the SPX at 2 points markets would have stopped functioning for a long

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
SheepDog-One's picture

I only choose the finest triple inverse leveraged ETF's myself, on full margin of course....I let the hoi paloi have these common inverse ETF's.

BTW whats with the DOW boner deflation into the close? No sucker fish to be netted higher?

Cdad's picture


BTW whats with the DOW boner deflation into the close? No sucker fish to be netted higher?

I think it had something to do with the fact that the BlowHorn [CNBC] alerted people to money coming out of fixed income [for about an hour and a half] before money started going back into fixed income.

Never mind that fixed income has been getting all the love, and for weeks, which the BlowHorn forgot to mention, but anyway, it also really could have something to do with only The Algo having any conviction because The Algo knows it can unload 100% of its long in 4.5 seconds , or the same period of time representing the average long holding period for a share of Netflix...I think.

As for the ETF topic, really they should be called GMFs [Gaping Maw Funds].  Other than that, I agree they are a wonderful instrument for creating systemic risk.  

**update:  seconds after the closing bell, and after a full day of irrelevant news coverage while the market went all "risk on" because more people signed up for Federal Unemployment insurance, the BlowHorn announces "taking risk off due to headwinds."  Maybe that is why there were no sucker fish? **

SheepDog-One's picture

Oh noez! Some fixed income sloshed around a bit....nice heads up Blowhorn!

oogs66's picture

the leveraged etf's have bigger problems...over large moves with reversals, they are so path dependent that their divergence is huge

Sam Clemons's picture

Am I the only one surprised this author just figured this out?  Hello 2009.

oogs66's picture

the leveraged etf's have bigger problems...over large moves with reversals, they are so path dependent that their divergence is huge

bigelkhorn's picture

The guy I follow saying there could be more down for the market on friday. 

His site is over at   

his stuff is magic, live videos are insanly good! and he called the crash back in 2008, he doesn't charge $900 bucks a month to join his site like those other SO CALLED idiot gurus!, in fact its so cheap to be a VIP member, I was almost in shock!!!. Well worth a look. 

Bam_Man's picture

Your "problem" only "gets smaller" until they do a reverse split on you. Then it "gets bigger" again. 

slvrizgold's picture

These ETFs are for retards.   Look at FAZ a 3x inverse financial etf.   You'd think that with financials dropping you'd make a boatload of money if you just stick with it.  WRONG.  Down 90+% if you've held for any period of time longer than weeks or days.  If you've held for a year or more your down over 99%!

Wealth extraction machines.

decon's picture

Interesting, I was wondering where the money I made on Tues. and Wed. in FAZ came from!

SwingForce's picture

Since April 2010, financials have been doing the whipsaw-jig described in C&D- sideways is lethal for both kinds of etfs +/-.  Funny the Author chose SPX to go to zero (which it probably would never do) but the banks actually do have a chance at getting there. FAZ will be one for the record books, eventually, as long as the inverse transmission under the hood doesn't blow out. Bungee cords & springs that's all, no stocks not even short stocks are owned.

Huge point to make- Author is correct in describing a slow, controlled descent as being most beneficial to inverse etfs. The Compounding Effect is phenomenal in that scenario, but a may 7, 2010 Flash Crash is not that impressive. 

The Fonz's picture

My 87 Chevy camper van has a transmission comprised only of bungie cords and springs, works great!

Id fight Gandhi's picture

These are only good for short term moves. The decay will destroy any profit. Get in get out and go back.

During the 08 drama trading long then short was a fun.

ZeroPower's picture

 if you've held for any period of time longer than weeks or days. 

Why would you? 

SwingForce's picture

In a mono-directional period of time, it would be called "compounding" and its exponential, just as the charts show. (ie, "IF" & "When").

agent default's picture

There is a surprising number of investment advisers out there that don't have a clue about the workings of ETCs and inverse/leveraged ETFs. A lot of money has been burned by these assclowns. 

HowardBeale's picture

Of course, as "luck"--and the law of large numbers--would have it, the ups and downs are near symmetrical, and thus, these decaying ETF's are no risk (as long as you have the reserves/margin to cover temporary spikes) vehicles for stealing near every penny received for the initial issuance. You have to love the reverse split on the SKF: an attempt to hide the nature of the inevitable decay. Levered ETFs? Mechanisms of theft.

DizzySailor's picture

Been all through the inverse ETF scam, anything more than a day trade and you are screwing yourself.

HowardBeale's picture

My question: Why are they legal, as they are truly nothing other than financiodegradable options.

The Fonz's picture

mmm... if they decay in sideward markets why is buying puts in the direction of the decay a bad idea? Also, 3x levered ETFs seem OK in trending markets. Probably a good idea to pop out for larger rallies. What am I missing here? Everyone seems to take it as obvious that these devices are a rip off. I seem to make quite a lot of money with them... so far. I understand they can collapse, it's a total risk of loss when the derivative unwind arrives. Perhaps someone would be so kind as to educate me, I thank you in advance. :)

P.S. If a levered ETF has more puts than calls could you also determine that it is probably in a sideways market?

InconvenientCounterParty's picture

pure freakin' poison.

Early is wrong, late is wrong. Right on time, is transient with a 1 day time constant..

Stick with options.

SwingForce's picture

Options on leveraged ETFs! Exponential² !

The Fonz's picture

I think I figured out that my last option on TZA was about 16x levered. Very fun way to dance around a core position and keep yourself focused on boring details in the markets. Its pretty cheap too, TZA options I buy are about 300 each.

Reductio ad Absurdum's picture

It's not just inverse leveraged ETF's.

All leveraged ETF's, positive or inverse, have the same mathematical behavior and will decay over time if the market fluctuates (which it always does).

The positively leveraged ETF's only appear to be doing well over the last few years because the market has been going basically in one direction (up) due to government manipulation.

If the market ever starts moving sideways for a length of time (fluctuating daily) then both SPXU and UPRO will head to 0 quickly.

Boilermaker's picture

Of course, they also compound if the direction is one-way over several trading sessions.

Holding SPXU for six consecutive down days would be highly profitable.

John_Coltrane's picture

Indeed, that is why the smart move is to short both leveraged and inverse types at the same time, strike price and duration by selling calls.  To control margin risk just sell call spreads on both.  The funds you might lose on one are completely balanced by the gain on the other even in a highly directional market.  (For example, while FAZ has lost 90% of its value from a couple of years back, FAS is barely even)  In a sideways market you make consistent money from the compounded time decay on both.  For example, I like selling both FAS and FAZ call spreads.   A great source of income!

RobotTrader's picture

They should make an 3x inverse ETF on the GDX for the fabled, oft-discussed "Ratio Traders" so they could really drive the mining stocks into the ground.

SwingForce's picture

DUST is a -2x, but they do great look at the 2x AGQ over the past 6 mos. RT you're on to it, they don't have to drive them into the ground, they can pound -1% each day and the next day is less than yesty (1% of 10 is 1, next day 1% of 9 is .90, etc). These inverse etf's will be the WMDs in reverse once GS et al. figures out they need to stomp on the footpump less and less each day to make the -3x compound exponentially UP.

Email for live edit permission, everybody invited.

dcb's picture

I use them very effectively with stop losses and have each charted. my rading style is four things with inverse etf's as well, tbt/tlt, eem/eev, sso/ sds, uco/sco, and cmd, djci. guess that is five. i just made about 10% on the drop, closed out today, my eev at a bit different, and the crude sings have been great for me with 10 percent moves up and down, so I am making 20% on the swing. I also trade udn, uup.

In all honestly, I'd like to cut down a bit .


I almost always have some buy stops in place for tail risk, and if you really pay attention to trading sso, and sds you can trade in and out during the day and max profits rather well.


I also rode dug from oil and 147 down, and rode eev.

the most use they have is you are good at Id peaks and bottoms. much harder in the middle.


Boilermaker's picture

There is nothing wrong with them if properly used.  In the short run, of course, they can really pay off well or leave you wearing a barrel.

I think everyone is well aware that using the leveraged ETF's, inverse or long, are short term sophisticated gambles.

What the hell is wrong with that?  Better yet, how is that fundamentally different than the bullshit rally today?  That's equally ridiculous and probably screwed anyone with a brain.

Just accept it as a casino and be done with it.  Bet accordingly.

Re-Discovery's picture

Agreed.  I will go so far as to say that you SHOULD use the positive leveraged ETFs if you truly undestand the investment thesis.  WHY?

1) Every 'investment' is biased to the upside.  This is why short selling is very difficult.

2) The opposite of leveraged direction trading is diverisification.  To diversify in a sideways market is to own treasuries without the sovereign guarantee, i.e. stupid.  This is to say that diversification is just a directional trade on several assets you have a passing kowledge of versus one or two you have of which you have in depth knowledge.

3) If you don't know what you are trading, dont trade.  If you do, optimize your trades through leverage etc.  If you want to eliminate risk, don't leverage.  End of the day, establish a thesis and trust it.  Otherwise, give you money to someone else to manage.

4)  We live in the time of directional speculation with a majority of asset managers who have been trained with broad market exposure diversification.  The real contrarian in these times focuses his investments on calls that he understands.  Leveraged ETFs just give more exposure.

5) Liquidity always trumps investment thesis.  Always keep dry powder because even the smartest of us is wrong 10 % of the time.  (and if you keep that 10%, you can build back to 100%.  Cant if you go to zero.

6) Alway book profits.

7) Always seek to limit losses (remember, as said before, all markets are biased to the upside.)








Havana White's picture

Great to buy their puts.

dcb's picture

oh, and on the nice big oil correction days we just had, and commodities they were great for me. I think that was 20% in about three days.

honestly, the way I make the most money is too program things in a few days before based on my charts. is things become oversold, I buy into my longs, and tighten my stops on the inverse etfs.

Thisson's picture

I think there is a fundamental difference between a "vanilla" inverse etf like SH and the 2x and 3x leveraged etfs.  Yes there is slight decay but it's relatively low.

While options are powerful tools, to make them pay you have to know both direction AND timing.  Since the keysnian cult keeps delaying the day of reconing, I will continue to to hold SH and remain patient.

Smiley's picture

I've used the 3x leveraged ETF's to great effect when day trading but you HAVE to put in your buy orders in during the morning's pre-trading session.  If you wait for the markets to open you might as well wipe your ass with and flush a fistfull of $100's.  If you hold them past the daily close you are completely retarded.

monopoly's picture

I like to trade them a little but not for long term. If you get the right side works well, even in an IRA.

AboutAverage's picture

Charts and math are amusing for college students interested in math who don't have a life. 

But what is more amusing is when you realize that Wall Street is equivalent to playing poker with thieves.   If you are dumb enough to put your money with these goons, then they are happy enough to steal it from you.   Most of these people running the show on Wall Street should be behind bars and the general public knows this.   The flim flam job of - look at the graphs and look at the math which explains this is nothing more than a side act and will not work to get people's trust back.  Bottom line - there is a problem in trust because their are total dirtbags working at these institutions who are potected by dirtbag politicians. Until people legitmately can vote politicians in office who will stop screwing around with the lives of all Americans and start throwing criminal bums in jail for massive fraud - it will be more of the same and continue to get worse.    Bananna Republic is no way to run America gentlemen!  If you don't care about yourselves, then perhaps you should think about your children or family.   Do you really want your childen/family growing up in a Bananna Republic?

pitz's picture

Big problem with the leveraged ETFs are the fees, and, if you actually make anything on them, you end up being stuck with capital gains tax to sell them and move into something less volatile to preserve capital.

Whereas, if you get a margin account and leverage SPY yourself -- at least at some point, you can stop increasing the leverage (long or short), without being forced to liquidate the position.


Stoploss's picture

The reason these things don't move anymore, is nothing more than volume. Compare the volumes of 07-08 long and short sides, that's [market] volume not etf volume, and the puzzle is solved. Compare mar 09 volume to may 6 volume, look at how they performed on those two days. What has Tyler been harping on for the last two years? No volume in the market.. That equeals zero movement for these etf's, long or short.  OMG.

holdbuysell's picture

Nice analysis. Well done.

Stoploss's picture

Forgot to add how to select which etf to use. Again volume is the key [etf] volume this time, not market volume. You want to look for an etf that has LOW volume. I use RTSA to short the rut, and im out today since 28. Notice the volume for today, go back and compare for other days and other etf's if you want. Since there is no need to put on a long this will be the only leveraged etf i will play, even if i play it again. Also stay away from too low of etf volume, anything under 10K a day, avoid like the plague. Good luck.

Slap That Taco's picture

"SPX at 2..."  Awesome. 

Nice work, but the folks here probably already know this-it's the guy holding FAZ as a buy and hold who needs to read this!

Anonymous Hand's picture

If this is your best idea for making money in a "S&P 400" scenario world, I feel really bad for your clients. Send them to me, please.

GoinFawr's picture

How about shorting ETF pairs and pocketing the fee decay?

Havana White's picture

Good idea but many prohibit shorting.  That's why I buy the puts when prices seem attractive - on the 2x and 3x - a few months out.  Just bot UPRO Sep70P (S&P500) and UWM Oct43P (Russell2K).  Decent enough time value to see some price erosion even if the bear hits the snooze alarm a couple more times.  Best, of course, is that exposure's limited to cost of premiums.

prophet's picture

They work extraordinarily well in trending markets.  Buying any of the 3X longs and holding in 2009 was superb.  They also did well in all the subsequent multi-month runs.

tbonetmoney's picture

There are a few ETPs whose leverage is reset monthly. SBND is one that may be very useful for people bearish on treasury bonds.