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Guest Post: TBT's Decaylicious Existence...Shown Mathematically
Submitted by QevolveQ Holdings
The investment world has been bombarded with leveraged ETF products. These products are specifically designed for use as short term trading vehicles...they are not meant to be held for long periods of time as the inherent decay factor will eat away at your principal (some levered ETF's decay faster than others, but they all decay). All too often folks write about these products without properly warning investors of the built in dangers. In this example, I'd like to mathematically show how the 2x levered short treasury ETF (TBT) stacks up over time.
Here is the mathematical breakdown on TBT's decaylicious existence...this example uses a snapshot of TLT, TBT, and long bond rates from 3 different time periods over the last 18 months (chosen specifically to show a constant long bond rate (5bps variance) versus the market price of TLT & TBT:
Note that TLT (1x long) & TBT (2x inverse) track the exact same index. Looking at the below examples, I layout the -28.9% return on TBT over an 18 month holding period with long rates & TLT virtually unchanged.
On December 28, 2009 the long bond closed at 4.70%. Prior to this, the last time the bond traded 4.70+ was June 10,2009, & in fact it closed 4.75 that day (which is 5bps better than our example, & close enough for a relative price comparison). The next most recent time the bond closed 4.70 was July 25, 2008...all 3 pricing dates for the bond, TLT, & TBT are included below:
30yr close 7/25/08 vs. 6/10/09 vs. 12/28/09: 4.70% / 4.75% / 4.70%
TLT close 7/25/08 vs. 6/10/09 vs. 12/28/09: $90.14 / $88.19 / $89.46 (notice the tiny -.68/-.75% difference in TLT over the course of 18 months @ equivalent 30yr yields...note that an estimated 23bps of this change is the expense ratio for the ETF)
TBT close 7/25/08 vs. 6/10/09 vs. 12/28/09: $71.53 / $58.77 / $50.88
At TBT's $50.88 price on 12/28/09, investors are a lot more than 5bps (in our example) from the June 10 price, in excess of approx 60bps, such as the move that happened between May 14, 09' & June 10, 09' that encompassed 67bps on the bond from 4.07 to 4.75 & a striking move in TBT from 48.94 to 58.77.
There's really no comment necessary on the 7/25/08 to 12/28/09 move in TBT...but anyone that has owned it that long, perhaps assuming flat yields over time would leave them in decent shape while maintaining the "short long bonds" exposure, has in fact lost -28.9% of their principal from by holding this instrument.
The point is, if you think long rates are going up, great....but if it takes 1 or 2 years for that to happen, you'll be grabbing your ankles for quite a while as the decay sucks away at your principal.
Anyone interested in maintaining short long bond exposure without the decay, take a look at TBF (the 1x instrument). I agree that TBT can be a great short term trading vehicle. But to sock it away in a portfolio for 1 or 2 years is just plain stupid, as the above example clearly shows.
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TBF is no better, when you look at how it tracks TLT, it has half the return since its inception. Someone else mentioned buying the TLT LEAP puts and selling the TLT LEAP calls, which probably would work better.
Why not buy the TLT LEAP puts (get long interest rates) as you suggest, but also sell some TBT calls (get short rates) and suck out some time delay as a hedge. Just keep selling the TBT calls until Geithner and Bernanke are out of fingers to stick in the dyke, and then sell a mountain of TBT deep in the money puts to get long rates, stop paying for the time decay in the TLT LEAPS puts, and suck a little more time decay out of the TBT options (puts) but from the other side.
I agree with you on this, TBF is not perfect. But I would point out that it does a better job of purely tracking the index over time (as opposed to the ill decay one experiences with TBT). I've not looked into LEAPS, though have found a decent market trading front month TLT options in anticipation of 5 to 20 bps moves in the bond.
DGP has been pretty good about holding its value. They must be doing a good job of rolling over contracts.
well done, and topical in light of today's responses to MHFT's short treasury suggestions
Maybe you zero hedge readers should consider options on the 30 Yr. U.S. T-Bond futures derivative.
As for the futures contract itself - they say futures require margin (a performance bond) but I believe that is fancy talk for "We will come and take your house, your car, your savings, and your business if a black swan craps on you."
Long leap puts?
Ja.
Typical options-trader rationalisations. What he meant to say was, "execute an Iron Condor with a Flying Buttress Hedge on the LEAPs."
Why these people bother with this stuff is beyond me. Options are soooooo manipulated, it isn't even funny. Oh, yeah. Way worse than stocks.
Trade 4X. You'll neve go back.
Investment strategy, Short the 2x and the -2x and then you get decaylicious returns
And get destroyed if they go one direction too long.
Are you telling me that you can get a general collateral locate on both the 2x long and 2x short ETF's for the same index? Any index would do. If you can, you will make a lot of money with a low risk.
SRS, SKF are poster children for time decay. TBT is a dead play, been there done that. Here was my day, i picked DRN for todays weapon. Mkt opened up, then sold off a little, i entered DRN at 137.02 ( you will never get the day low ), then like clock work, a rally into the close and i jumped out and got 144.47 on the 200 shares. I buy/sell with mkt orders. Thats how you use leveraged etf's.
Compared to everyone else, im using caveman technology to boot. Stay away from the old products.
how else do i bet on rate explosions?
signed - small time amateur
interest rate futures
be careful, there is also a ton of carry in the bonds. If you are a bank you borrow at zero and invest in treasuries with tremendous carry. It is also a 0 risk weighted asset for Banks. Calculate how much it costs to be short each day in bps and see if it is worth it. Might be worth 2/10's steepener to offset the carry but that is a crowded trade (look at cftc net specs)
finally someone on the 'contrarian' circuit understands why shorting bonds is not a good idea!
Would Profunds Rising Rate Opportunity Fund be a good choice or does it also suffer from "decay?"
Would Profunds Rising Rate Opportunity Fund be a good choice or does it also suffer from "decay?"
Is it correct to call it theta when it is not really time decay in options nomenclature? the result may be the similar but the prospectuses state pretty clearly that its designed to provide 2x the daily move. therefore isn't it the day to day volatility that create the perceived tracking error. thanks for expanding on my earlier comment as I think whoever madhftrader is is a bit off base on this one.
good stuff - thanks.
It's not time decay or anything of that sort. It is simply a fraudulent or rigged syetm as set up in all the ultra-prospetuses. Favorable moves get rewarded less than non-vavorable moves get penalized: a 10% movement of the underlying in one's favor (in the direction of the product, eg, up for an ultralong) is counted as 1.10 ( x investment), while a 10% move against is counted as 0.90 ( x investment). You can easily see that if you keep multiplying 1.10 with 0.90, you end up with near zero. Gains are rewarded less than losses as per prospectus. These products should be banned because the odds are stacked up against the investor from the start. Futhermore, nobody bothers to inform him of this. But maybe today that is asking for a bit too much?
Yes it is time decay, and they do bother to tell you of all the risks involved, and they should not be banned.
It's called a prospectus, read it, learn it, live it. For some, these are way too complicated, im sensing you fall into this category. For me it is an easy way to generate cash, jus like Benney boy!
www.direxionshares.com
Please, by all means, educate yourself.. You are embarrasing yourself.
Hey smartass: I've read the pro-shares prospectus and although I'm too lazy to read direxion, I have would bet it's the same trick. How come you can't see this? Or are you have a vested interest? Because you've probably not worked in fund management, I will repeat: If you treat a 10% gain as x 1.10, while a 10% loss turns into 0.90, there is an in-built bias of the price to approach zero.
I made 8500.00 today.. That's no trick.. Just Wednesday.. I do work in fund management, i manage my own funds! Admit it, you're jealous... You must be a Cramer fan.
it's actually called "mathematics," although your end point is correct.
i'm surprised you're talking the time decay angle (if the index doesn't move on a day to day basis, you don't get any decay at all apart from the management fee) - it's much more of a volatility thing, and it's why SKF and SRS do even worse than TBT - the vol is much higher on those indices.
Time decay is how you identify a dead play. The indexes i use move up to 5% a day, that's all im after. Once that stops, i move on to the next newest index play.. Also, volume is an enemy, that is your number one tip off that decay has happened without question. High vol = low return. Long or short.
From where I come from... if my $100 stock goes up 10%, it is worth $110. If my stock goes down, it goes to $90. If it drops 10% to $90 and then climbs 10%, it will go to $99. Not sure I understand your complaint...
The so-called decay is a function of churn; markets moving back and forth eat away at your principal. Every time the yield goes somewhere it's been before, you're going to have a lower value than you did the last time. The question is: where does the eaten-away-at principal go? It doesn't just evaporate.
If markets make a more-or-less unidirectional "long march" *in either direction*, you'll do much better with the TBT than with 2X the index. In other words, in this scenario, the tracking error works in your favor. This is the benefit you get for taking on the cost of decay.
In a sense, you could thus view a long TBT position as being short both treasuries and volatility in treasuries.
In theory, if you like the double-exposure, but want to exactly track the index, (i.e. not sell the volatility) you could buy more TBT on the days it's down, and sell on the days it's up. This would "sterilize" the opposite action the fund sponsor takes to keep its exposure at 2X capital. Ignoring trading costs, your returns would exactly mirror -2X the returns on the treasury market. Of course, doing this means that you run the risk of running out of dough if the market makes a sustained rally, and also that you have to have undeployed capital at the ready, which could be inefficient.
The so-called decay is a function of churn; markets moving back and forth eat away at your principal. Every time the yield goes somewhere it's been before, you're going to have a lower value than you did the last time. The question is: where does the eaten-away-at principal go? It doesn't just evaporate.
If markets make a more-or-less unidirectional "long march" *in either direction*, you'll do much better with the TBT than with 2X the index. In other words, in this scenario, the tracking error works in your favor. This is the benefit you get for taking on the cost of decay.
In a sense, you could thus view a long TBT position as being short both treasuries and volatility in treasuries.
In theory, if you like the double-exposure, but want to exactly track the index, (i.e. not sell the volatility) you could buy more TBT on the days it's down, and sell on the days it's up. This would "sterilize" the opposite action the fund sponsor takes to keep its exposure at 2X capital. Ignoring trading costs, your returns would exactly mirror -2X the returns on the treasury market. Of course, doing this means that you run the risk of running out of dough if the market makes a sustained rally, and also that you have to have undeployed capital at the ready, which could be inefficient.
Who's the idiot who posted the same comment twice? Oh- that was me. D'Oh!
at the end of the day the relative decay vs option decay is what matters. i mean it is like buying a super long LEAP with decay but the difference is as long as the ETF doesn't go under (ie disappear) it could pay off.
This post MIS-STATES the issue a bit...
If you are LONG the 30-yr, and 1-yr later rates are the SAME, should'nt you EARN the carry (4.7% annual?)/
So it looks like decay and costs on 1x TLT are about equal to the rate level? Its not 23bps, its 470 bps!
So many people continue to say that these should just be used as short-term trading vehicles (and there's nothing wrong with that) , but they completely ignore the fact that because of their triple-leveraged nature the options are usually excellent to use in short strategies.
My favorite is to buy both the long and the inverse and sell the calls.
Well yes it's called negative leverage compounding, market whipsaws will kill you over time. Check out URE and SRS (double positive and double negative IYR) each issued a couple years back at 100, now both around 7.
But for those who'd like to short remember positive leverage compounding - which plays out when prices move in the right direction for several business days - then the double compounds positively, remember SRS at 298 at the end of 08?
Best strategy is to short maybe 100 different multiple ETFs, claim to support valuations with equity swaps, raise and spend gigantic amounts of money, live like a king until your hedging model fails, then disappear blaming counterparties for the debacle.
You're Joe Cassano, right?
Does anyone know if the Profunds Rising Rates Opportunity mutual fund - RRPIX - suffers from the same type of "decay?"
Am I correct in that this decay factor would be very beneficial for someone who is selling naked call options on these etf's, with an expiration of several months out? It would function to help pull the etf price further away from the strike price?
All other factors being equal yes that is correct.
But if prices move in the wrong direction for a sustained period positive compound leverage will eat you alive. (Remember SRS at 298 November 08).
Better to be long leap puts, a right rather than an obligation, with the added benefit that if these exotic ETFs self destruct when the music stops, failed equity swap counterparty whatever, that's another win for you.
much on (OTM calls) or being long (in the long term) on TBT
Corporate bond ETFs, read it here:
http://volatilitysmirk.blogspot.com/2011/02/coming-us-sovereign-debt-cri...
(second part of the post)