Well, hello everyone. Welcome out to this Maverick Trading presentation on leveraged ETFs. Hope you’re enjoying yourselves trading. We’re gonna talk about leverage. When we talk about leveraged ETFs, sometimes it’s two times, three times levered ETFs, there’s some good and bad with these. In some cases, more bad than good, and I’ll talk about that as well. As always, if there’s any questions you have, anything that we can address throughout the presentation, we’ll do that during the class here. Let’s jump right in and look at leveraged ETFs.
ProShares launched the original leveraged ETFs in 2006. In the 10 years that followed, there were more than 200 that came onto the marketplace. There’s probably 300 or 400 as of today. Most are offered by two big firms, ProShares and Direxion. Those are the two big leveraged ETF providers. Now, again, when you’re talking about leverage, the only way to get leverage is, basically, to use leveraged, or basically, derivative markets to acquire that leverage. If you’re gonna get two times or three times leverage, they’re using derivatives in some form. They’re available for most major indexes, like the Nasdaq 100, the Dow, the S&P, they all have leveraged ETFs.
At this point, you can probably find a leveraged ETF for almost anything. You can find one for the gold markets. You can find one for oil. You can find one for natural gas. You can find one for certain sectors, like bio-techs, or this, or that. These funds look to keep a constant amount of leveraged amount during the time period, such as 2:1 or 3:1 leverage ratios. That means that if I were to go out, let’s just use a hypothetical, and the S&P is a simple easy one to understand. If I were to go out and buy the S&P 500, and it went up 1%, of course, I’ve made 1% in my trade. I can buy stock, or I could trade an option on that, but I’m get one for one type of ratios if I’m trading the asset itself. So, S&P goes up one, I make one. Plus one equals plus one.
Well, of course, if I’m levered at two times or three times the ratio, then if the S&P goes up 1%, guess what happens? I make more money. The S&P goes up one, I make two, if it’s two time levered, or three, if it’s three time levered. That’s how it’s designed to work, so 2:1 leverage, you’d be up 2%. 3:1 leverage, you’d be up 3%, and so on. The problem is that if it went against you, those same gains now become losses. In other words, a 1% down move in the S&P, a -1%, you would have 2% losses if you were on the wrong side of the trade, if you are 2:1 levered, or 3% in losses if you were 3:1 levered.
Then, there’s some other difficulties with these as well, which we’ll talk about, but that’s how the ratios are designed to work. Think of them on a percentage basis. Instead of making 1:1, you’re making 2 or 3:1 percent percentage moves.
Leveraged ETFs respond to share creation and redemption by utilizing exposure to the underlying index with derivatives. The derivatives most commonly used are index futures, equity swaps, or index options. The cash that they have is to meet the financial obligations that arise from losses on the derivatives. How do they do that? Well, basically, they’re going to create, or leverage up, an assets so that their calculations suggest that they’re about two times or three times levered. The problem is that not all of these assets are going to move exactly as planned. In other words, if they use an equity option, let’s say, well, if I use an index option, I can get a pretty good sense of how much it’s going to move as the S&P moves 1%. But there might be changes in volatility that could be good or bad. There might be some time decay, and those sorts of things are not accounted for. They’re trying to get 1% to 2% or 1% to 3% moves on a daily basis, but if you extend that out over a period of time, over weeks or months, they’re going to underperform that almost always.
These are high-risk, high-cost levered ETFs. In some cases, they change you a 1% expense ratio or more. The bigger risk, the bigger pitfall to them is really that loss of value in the derivatives that they’re holding. A prime example of this are the volatility ETNs. They are kind of a disaster in the way they’re created, and I’ll show you that process.
Here’s the S&P, and here’s an example, this is a Direxion three times-levered bear. Now, the symbol is SPXS, so I could trade the S&P 500, or I could bet against it, in other words, this is a bearish ETF, so it goes up when the market goes down. Notice that recently when the market was sliding, it was going up. Well, if I look at the share price on this, the percentage move should be roughly three times that of the S&P 500, meaning this move from 23 or so to about 28, that was a $5 move from 23. That’s a 21.7% move. That’s how much this three-times bear went up. In theory, the S&P 500 would’ve lost, how much? 7% during that move. The S&P from its peak, which is the trough of this, to its low point, which is the peak for this, they move in opportunity directions, should’ve moved about one-third as much. This went up 21.7, we would anticipate that the S&P 500 probably dropped about 7%.
Sometimes it’ll be a little less than that. They won’t move perfectly in tandem. Let me show you an example of what I’m talking about. Let’s go to the S&P 500 itself, and as we do that hold on tight. I’m gonna pull up the actual S&P chart, and we’re just gonna do some math on this on the flip side. As I look at it, here was the peak, and here was the trough. We can look at the percentage move on that. Now, derivatives can move a little more or a little less. Well, let’s do … I’m gonna add price labels here. As I do that, 2815 to 2631, so 2815 minus 2631 is a drop of 184 points, divided by its peak share price, which was 2815. That’s a drop of 6.5%. The S&P did drop about that 7% as SPXS went up about three times that amount.
We can make it a little bit … I didn’t go perfect on my SPXS calculation. If we use the price labels and do the same thing, 2307 to 2808, so 2808 minus 2307, divided by 2307, it was 21.7, so pretty accurate. Notice that they don’t link up perfectly. Sometimes it’s to the benefit of the ETF, more times than not, it’s to the detriment.
Now, why did SPXS, in this case, go up a little more than three times? Usually it would go a little less than three times. The reason is volatility. Because leveraged ETFs are using options as instruments as an example, does an option inflate in value more when the market goes down? Remember SPXS going up is the market going down. When the stock market goes down, we know the VIX goes up, and that’s the cost of options. Look at how much options went up in value during that period of time. The VIX will show us that. This is the cost of insurance. This is the fear gauge and so on. During that market sell off, option values, opt premiums, went up dramatically. There was a little bit of a benefit to being in a levered ETF, but that’s the more rare circumstance. That is the less common. So, when volatility surges and you have a sustained period of volatility, you’ll actually get a little bit better return in some cases on these levered ETFs. The problem is that over time, most of the time, they underperform. Let me show that in calculation form.
So, let’s do this. I’ll go weekly. I’ll go back an extended period of time, and we’ll do the same type of math. Let’s go back two years. Now, let’s see what happened here. I’ll take a couple of important points. Let’s go back to the peak here, which was early 2008. That was the end of January 2008. We hit a peak of 2872. We’re currently trading 2667, so I can see how much we’ve gone down in the S&P for this year, from roughly January through the end of November, how much have we lost in value? Well, 2872 minus 2631 is a drop of 241 points, divided by its high point of 2872, and we’ve gone down … Let me do that again. I hit the wrong button. 2872 minus 2667 is 205, divided by 2872. We’ve gone down 7.13%. That’s how much it’s gone down over that period of time.
Now, in theory, the SPXS should be up about three times as much, so it should be up 21% over that period. Well, let’s look at it and see if that’s accurate. I’ll go to SPXS, and we’ll say, okay, from its trough, 24.14, to current prices, 26.91. So, 24.14, 26.91 is the current value. That’s 2.77 above from 24.14. That’s a gain of 11.47%. Do you see something went wrong there? It should be up 21%. If it’s a three-times levered, if the market goes down 7, it should be up 21. Instead, it’s only up 11%. What’s the problem here? You can all answer it, right? These don’t keep up that performance for extended periods of time. There is a decay of value. So, even though the market’s lost 7%, you’re only up 11, which is only a li more than one time, it’s not even two times the performance. Guess what? If you hold this for another year, and another year, and another year, it’s going to continue to dwindle and deteriorate in value over time. The only way to really use these is a short-term trading vehicle. Very, very important that I emphasize that point.
They are a hedging tool for short-term, very, very short-term, trading opportunities, and that’s it. Some of the volatility ETNs are even worse. Look at something like, I have this big chart of VXX. Let me show it to you. This is VXX since inception. Now, this isn’t even a levered ETF. This is just trading, and it’s supposed to capture the volatility. It’s supposed to capture the VIX moves. Well, if I take this back to 2009 when it was created, look at the share price over here. This suggests that one share would’ve cost you $105,000. Do you think that they took this, and opened it up in the market, and had one share costing $105,000? Of course not. When it opened for trading, it was probably trading at 50 bucks a share. What’s happened here is that they have reverse stock split this so many times that what it shows is that for every 100 and 10,000 invested early on, it’s worth $36 today. That’s how much deterioration has occurred. These are terrible, terrible instruments. The volatility ones are the worst offenders. Well, you can see it in SPXS, and SPXS is not as bad as these volatility ones.
These volatility ETNs are a complete train wreck, so many trades just try to profit from the decay that happens in these. Understand, some people say, “Well, what if there was another crisis? If there was another crisis, would it get all the way back up there?” Heavens no. Not even close. If there was a massive crisis, this might go from 3650 to $150 per share or something. I mean, that’s about best case scenario, even if we had a crazy crisis. It could go up in value for a period, but over the long haul, these are decaying assets. Why does that occur?
Well, specifically in these volatility ETNs, there is something in the futures markets called contango and backwardation. If we look at the VIX futures, which is what this utilizes, the VIX does not trade at the same value in the futures across every month. For example, if we look at the December futures for the VIX, it might have a reading of … I’m gonna throw out some hypotheticals. Here, would be the normal pricing. December VIX might be at 18. January VIX futures might be trading at 19. February might be trading at 20 and so on, something like that. That’s normal pricing. That’s what they call contango, and that’s normal for the later dated to be trading at a premium. Backwardation happens when there’s a big spike in volatility. When something short-term is really risky, then futures go backwardated. Just like it suggests, it’s backwards. It’s not normal. A backwardation would be something like December at 23, January at 21, and February at 20, or something like that. That would be backwardation. It’s backwards to how it’s normally priced. Why does that happen?
Well, backwardation happens when there’s a big short-term risk. For a good example of this, let’s take oil futures. Oil, we pretty much know how much oil is gonna be produced, give or take a few hundred thousands barrels and whatnot, we have a pretty good idea. Out of Saudi Arabia, they’re gonna produce this much, and Canada’s gonna produce this much. We have a pretty good sense of how much it’s going to be, but what if something major happens? A big war breaks out, and they shut down the Straits of Hormuz, or whatever, and all of a sudden, there’s a big risk that there’s not gonna be as much oil as people had planned for. Well, people will say, traders will say, well, by February, they’ll get it figured out.” But by December, we might have a shortage. We might have a major shortage, and people need oil to keep working as business. So, what happens is the short-term oil futures spike. They say in the short-term, it’s gonna be hard to get enough oil, but by February, these things will be ironed out. Well, if it’s shut down here, Canada’s gonna ramp up production, they’ll make up for it. Everything’s gonna be fine, right? We’ll have enough oil by February, but that doesn’t mean in the short-term we will.
Short-term supply disruptions could cause backwardation. In the VIX itself, backwardation comes from risk. Recently, we saw a little backwardating in the VIX futures, where the December, and whatnot, got more expensive than the later, because they thought, well, there are some short-term risks happening in the market right now. So, things kinda blew out that way. The norm, though, most of the time, 90-some odd percent of the time, it’s in contango. If it’s in contango, these ETNs, like VXX, UVXY, they’re a complete disaster, because what happens is, they have to own these futures. When December expiration is approaching, what do they have to do? Well, they own all these contracts at 18, and they still need to own the same number of contracts, so they sell their Decembers, and they buy February in their place. How good a deal is that for them? Well, it’s horrible. They’re selling a VIX at 18, and they’re buying it for 20. Then, what happens when February comes around? Well, they have to sell it for 18 and go buy April for 20. Then, when April comes around, they have to sell it for 18, and buy June for 20.
Do you see how they’re losing value every time they’re selling the short-term that trades less expensive, and they’re buying the longer term, which trades more expensive. If you sell something at 18 and buy the same number at 20, well, you can’t buy the same number. In other words, let’s say I had 100 bucks to spend, if I sell it for 18, well, I can sell five of them, let’s say, for 18. Well, that brings back in 90. That’s not enough to get five of these, so I can only buy four of them and so on. They’re losing value, and then the next time they do it, they can buy fewer contracts, and the next time they can buy fewer. This is why this is just a deteriorating asset. That same thing is happening, this same dynamic is happening, in all of these levered ETFs in some capacity. There is no way to avoid it fully other than it does flip in your favor if futures of backwardated.
When futures are backwardated, and this is the point of emphasis today, when futures go backwardated, you can actually get a little bit better value. Remember we looked at SPXS, and we said look at it here? And we said, wait, it went up 21. It went up a little more than three times what the S&P fell. Why did it do that? It was due to the backwardation. It caught a little bit of a tail wind here due to the backwardation of the futures contracts. The other reason … I see a comment here, and that’s a great point. Thank you for bringing that up. The other reason people will use these is … Say you have an IRA. You have a Roth IRA. Well, you can’t short stocks. You cannot short the market and profit or hedge on it going down. Buying SPXS, though, buying within your IRA is allowed. So, if for a couple of days, or a week, you wanted to be hedged, or something like that … Oops. I’ve got some pop ups chart coming here. Sorry about that. Let me get that off the screen.
So, if you wanted to be hedged for a couple of days, or something, could you buy SPXS in your IRA? Yes, that’s allowed, and it is shorting the market. You are realistically three-times levered, bearish, on the market, so that’s one way to utilize that. That’s a great point.
Let me go over and show you some futures contracts, and we’ll look at a couple of things here together. If I pull up my IB screen here, let’s build some futures together, and as we do that, we’ll be able to analyze whether it’s in contango or backwardation. We can look at a couple of different markets. Let’s take oil. If I type in CL, not Colgate-Palmolive, I wanna come down here to Light Sweet Crude futures. If I click on the futures, maybe we’ll add a few of these. You can actually see the prices already. You can already tell that it’s in contango. Let’s add maybe three of them or something. When we look at it, this is normal pricing in oil. Why? Because the longer term trades more expensive than the shorter term. It’s not backwards. January futures contracts for oil 50.70, February 50.87, March 51.03. That’s contango. That’s normal pricing structure. It’s not backwardated. If something were to hit the market, it could turn backwardated.
Let’s go to the VIX. I mentioned VIX futures. They normally have a lot of contango. What’s interesting about the VIX right now, and I’m gonna point this out, is that it’s a little different. Now, these are really short-term. Let’s go to some of these monthlies, okay. Oops, that’s not what I wanted. I want the monthly contracts here. Let’s go December regular … Oops. I just pulled up the VIX options, still want the futures. That was a habit, clicking on the options there. Let’s go out a little further. We don’t wanna go 2019 necessarily, but let’s go out … Looking at this one, that’s December 19th. We can go January 2019, something like that. We can go February, and that’ll give you a few others to look at.
Realistically, if we’re looking at the monthly options, the VIX is in contango as well, meaning if we look at the price, it’s normal pricing. December monthly, 19.10, January monthly, 19.45, February monthly 19.50. There’s not a huge contango there. Most often, it’s more widespread. Recently, we had backwardation that’s come out of the market the last few days, but we did have some backwardation. If I pull up, as an example, let’s pull up a chart. Here’s the VIX contract. We’ll go daily, and let’s just pick a spot here. If we go back four days, on the 20th, it was trading up there at 21.07 four days ago. Well, if we look at some of these others, chart of that four days ago, it was trading at 20.92 at its peak. See how the January was trading 20.90. Let’s write it out so you can see it. January it was at 20.90, or there about, at its peak. 20.90, that’s not a very good … Okay, and this was at 21.17, or whatever. It was about 30 cents higher you were backwardated in this.
That was a small time period where that VXX, and UVXY, and some of those can work and actually have that benefit in their favor for a short period of time. But it was not long-lasting and whatnot. It’s now come out of the market, but that was a little period of time where some of those VIX ETNs, they were working for a couple of weeks, where they actually had the wind at their back, and they had some of those benefits working their favor. Whereas 90 plus percent of the time, it’s not.
Now, can we trade options on these ultra levered ETFs? Absolutely. If we say SPXS, if I look at that, I can come in here and pull up options. Here’s where it gets a little tricky. You have to think about these things and piece it out. If you’re buying SPXS, you’re betting on it going up, which means you’re betting on the S&P going down. I would buy call options on SPXS if I’m bearish on the market. I could buy put options on it if I were bullish on the market, ’cause this is moving opposite direction. So, if I go to January, hypothetically, and I bought the 26 strke call, what have I done? Well, I just put leverage on top of a three time levered ETF, so I’m leveraging something that’s already three times levered. That’s aggressive, of course. If I look at that from the standpoint of risk and reward, what’s my risk and what’s my reward? Well, these calls will go up in value if the underlying goes up. Really this is a good way, if you wanna hedge, it’s actually a good way to get hedged, because I’m leveraging something that’s three-times levered, so it’s gonna be responsive in the short-term.
If the stock market were to crack in the short-term and drop 5%, I might get a few tail winds here. Number one, I’m in a three-times levered ETF, so SPXS should go up 15% by itself. It should be three times. If I get some backwardation in the futures, it might be up 16%, 17% because of that tail wind. Then, on top of that, I’m getting a leveraged ETF here. I’m buying calls on it, so my call options have a big jump in value and may gain from volatility spikes. If volatility spikes up, all options become more expensive, calls and puts alike. The more bearish the asset is, the more it inflates. So, these calls would be likely to inflate more with the VIX rising. If the S&P drops 5%, the VIX is going up, all of these things become a tail wind. You can see why, as traders, we wanna utilize these, but very, very selectively, because that’s a lot of tail winds that you have that can work in your favor.
Now, let me tell you the downside. What’s the downside? Well, if I buy calls on this leveraged ETF and the market goes sideways, I’m gonna get hammered on multiple accounts. This call’s gonna lose value, because SPX is not moving. It’s gonna lose time value. It’s gonna have volatility dropping out of it. Options are gonna deflate in value, go down across the board, because markets are not volatile. They’re not moving a lot. The VIX going down, in other words, devalues all options, calls and puts alike, and I have a little decay in this due to the fact that, again, in sideways, or upward moving markets, it won’t be three times as responsive. It will be a decaying asset, so I’m adding decay to decay, and I get twice as much, or that type of thing in terms of deflation.
I think I’ve hit the point that you wanna be very selective with these. They can be a great vehicle to utilize in those very short-term big drop in the market. Watch these futures. If you take nothing else from this class, when futures contracts go backwardated, the hair on your neck should stand up a little bit and say, okay, we have more risk. Markets are telling us we have more risk than normal. Doesn’t mean it’s gonna stay here, but it can be a period of time where looking for an entry into these can be very helpful. In terms of this market, there have been, actually two times, we’ve gone backwardated in the VIX this year. Only twice. Where did it happen? Let me go back to our S&P chart here. Let’s go back full years. I’ll go back 11 months. That’ll take us back to January.
When the stock market started to get hit in January, the VIX and futures contracts went backwardated, and you can see how much turmoil and whatnot there was. They wanted backwardated here when the markets … I take that back. There were three times they got backwardated, and here when the market, again, got hit pretty hard. It’s not that … I mean, look. It was sustainable quite a bit longer from where it got backwardated. When it started to move backwardated in the VIX, it probably fell another, I don’t know, 6%, 7%, 8% in the S&P. It probably fell another 2%, well, probably 3% here and then bounced, and then fell another 5%, 6%, 7% here. Then, it did go backwardated temporarily in here recently. I mentioned that. It wasn’t as big a backwardation, but it did get backwardated here a little bit recently. Was there an increase in risk in the markets and more turmoil, and have we dropped a little further from where it got backwardated? Yeah. We’re down a couple of percent from those levels, so …
They don’t necessarily last a long time, these periods of turmoil, but they can be violent in the short-term, and if they drop another few percent over the process of a week or so, that’s about right for those ultra ETFs. You don’t wanna own them for four, five, six weeks. You definitely don’t wanna own them for months. And you absolutely, positively don’t wanna hold them for years. You wanna be in them and out of them within a very short period of time, few days to a week or two at most I would think in most cases.
Hope this was helpful. We’ll leave it there. Thanks everyone for being here. See you next time. Goodbye, everyone.