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| User Info | Answers to Some FAQs about Inverse ETFs in forum [Newbie] | |||
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Foxymoron Posts: 10364 Incept: 2007-08-20 
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Answers to Some Frequently Asked Questions about Inverse ETFs The inverse ETFs (QID, SDS, et al) seem to generate the same questions again and again, so I thought that a FAQ of sorts might be appropriate - if someone asks any of these questions in General or elsewhere, just point 'em to this thread... What are inverse ETFs, and how do they work? By using various derivatives, some ETFs attempt to produce the opposite movements of various indices, just as if you were shorting the index directly. Some ETFs take this even farther, attempting to produce double the opposite movements of their underlying indices. For example, the PSQ ETF attempts to move opposite the NDX, while the QID ETF attempts to move double the opposite of the NDX - so, if the NDX moves down 1% on a given day, one would expect PSQ to be about +1%, and QID to be about +2%. Note that because derivatives are being used to approximate the changes, the correlation between the underlying index and the ETF will usually differ by some small amount. There are at least two companies providing inverse ETFs - ProShares (http://www.proshares.com) and Rydex (http://www.rydexfunds.com). See those sites for a more complete list of the available inverse ETFs and their prospectuses. Why doesn't the gain/loss of my inverse ETF correspond to the loss/gain of the underlying index or sector? There are two main reasons for this - staggered close times and degenerative price decay. Staggered Close Times Let's use NDX/QID as an example (this same effect applies to most, if not all, of the inverse ETFs). QID tracks the NDX, and attempts to produce results that are 2x the inverse thereof. Like most indices, the NDX closes at 16:00 EST. Like many index-tracking derivatives, QID closes at 16:15 EST - 15 minutes after NDX closes. This fact is the source of virtually every question about the accuracy of its tracking. Let's look at a concrete example: NDX closed on 15jan08 (at 16:00) at 1894.09. It closed 16jan08 at 1872.29, or about -1.15%. Thus, we would expect QID to gain about 2.3% on 16jan08. QID closed on 15jan08 (at 16:15) at 46.50. QID closed on 16jan08 (at 16:15) at 46.60, or about +0.22% - nowhere near the +2.3% we expected. But wait - we're comparing apples and oranges here. Remember what happened after the close on 15jan08? The earnings announcement from INTC created a strong negative reaction, which caused QID to pop up before its 16:15 close. Let's look instead at what was going on at 16:00, when NDX closed. QID was at 45.47 at 16:00 on 15jan08, when NDX closed, before Intel blew up. QID closed on 16jan08 at 46.60. That's +2.5% from the 15jan08 NDX close. QID gained more than 2x the inverse, not less! Degenerative Price Decay A forum user recently commented: Quote:Last week, when the QQQQ traded 47.00, I remembered that the last time they were in this range the QID was also 47.00.Welcome to the world of degenerative price decay, and why the 2x inverse funds might not be such a good idea as a long-term play. QID's apparent "failure to meet expectations" was caused by the sharp price moves in early November and early January. Let me first create a simple example of degenerative price decay: assume there's a stock (XXX) that trades at $100 on day 1. Let's then say that it goes down 1% every day for 10 days. The price, day after day, would be: 100.00At this point, if the stock went back up by 1% per day, we'd see: 91.34- notice that we're back near $100.00, but we lost a dime in the process. Now, what if it went up 10% in one day, instead of going up 1% per day for 10 days? You'd go from 90.44 to 99.48 - a loss of $0.52, five times worse than the loss from the more gradual 1% per day move. This is because of compounding - 1.01^10 is 1.1046, or 10.46%, almost a half-percent more than a single 10% move. If you look at QID, it has tracked the NDX (and QQQQ) remarkably well since its inception. However, most of its moves were less than 2% per day, and the decay was small enough to disappear in the noise. But when QQQQ dropped 11% in just four sessions in November, QID moved 25% in that same time span - and lost a lot of ground in the process. A similar move at the beginning of January also ate away some of the value. The 2x inverses are great short- to intermediate-term plays, and they're wonderful if the market is just grinding lower. However, in a volatile environment, they may not give you quite what you were looking for... Counterparty Risk There are some open questions about potential counterparty risk in the inverse ETFs. I don't have all of the answers, but there was some good discussion in the General forum back in October, 2007, which can be found here: (http://www.tickerforum.org/cgi-ticker/ak....). If you have any newer or better information on potential counterparty risks, please note them here (or somewhere - this is an important topic). (EDIT 20aug08: More interesting discussion re: Counterparty Risk can be found here: http://www.tickerforum.org/cgi-ticker/ak....) Last modified:
2008-08-20 22:34:40 by foxymoron
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Vrb747 Posts: 1161 Incept: 2007-09-02 South Florida
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This is not just for newbies. I consider myself just a tiny  step above a newbie and I never could understand the inverse ETF relationship with the underlying. Wish there was a rating system. This way we could rate the superb posts like this one and make it easier for future readers to find them.
---------- Disclosure : I usually dont know WTF Im talking about
2008-02-03 14:10:05
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Snooze Posts: 1652 Incept: 2007-07-09 
florida Online
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Foxy.....Thanks for all the effort you put into maintaining an educational foundation for the forum....Contrary to your enjoyable avatars....you're not just a another pretty face
---------- We're on a journey - and we don't know it - back to a nation of communities where your character really matters, and where character rests on whether your deeds comport with truthfulness......KUNSTLER
2008-02-03 14:15:22
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Fidgit Posts: 14065 Incept: 2008-02-18
AllyBammy
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Thx for this Foxy - invaluable!
---------- I say it's spinach, and I say the hell with it.
2008-07-30 22:40:36
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Vegasradar Posts: 3956 Incept: 2007-07-11
CA
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 Thanks Foxy! You are a wealth of info!!! Just saw this thread after Fidget bumped it! Maybe Karl can pin it? ---------- Remember, all Bennie has is dollars. He destroys the currency, he destroys himself. —Karl Filling in the Pieces- an economic overview: http://storage.denninger.net/ppt/teapart....
2008-07-30 23:42:05
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Bozonian Posts: 14033 Incept: 2007-09-01
PFT - Pure F'n Tin
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You left out one very important question. How do they work? Generally I mean. Since stock prices are based on bid/ask, then aren't the prices of the ETFs also based on bid/ask? If that's true, then that means they can't be based on the value of their underlying securities. They are priced at whatever someone is willing to pay for them. But if that's true, why do they seem to follow the moves of the underlying (either with or against)?
---------- I'm so depressed about outsourcing I called the suicide hotline and got a call center in Pakistan. They got all excited and asked me if I could drive a truck. Everything I write is my opinion and not to be considered proven fact. Nothing I write should be considered financial advice.
2008-07-30 23:50:06
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Watchfuleye Posts: 54 Incept: 2008-06-16 England
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The bid/price of ETFs is based upon the price that people are prepared to pay for them. In the case of conventional ETFs, you are buying a share in a pool of securities - the value of the share you are buying is transparent and easily calculated (it's basically the weighted average of the market price of the underlying stock). As a result, the bid/offer don't deviate far from 'market value'; at the very least, market participants can arbitrage between the ETF and the underlying stocks (if the price of the ETF is too low, market makers can buy up ETF shares, then destroy them by withdrawing the individual underlying stocks from the fund and selling them for thier market value - making a small profit - the opposite also applies) - this tedious job is essentially completely delegated to computers. In the inverse ETFs, it's similar - you are buying a share in a pool of assets. However, in this case it's a pool of cash and derivatives. The problem here is that the value of the derivatives is less well defined. The notional value is only calculated once per day at closing time (or slightly afterwards). This means that during the course of the normal trading day, the price people are prepared for shares of the ETF is not based simply on the move in price of the underlying security (in a similar manner to how the price of options doesn't follow a simple relation to the price of the underlying stock). At the end of each day, once the value of the derivatives is calculated, the value is published in a news release, which states the total value of the assets represented by 1 share in the fund. E.g. at close of business yesterday SKF was trading at $121.31, but each share has $121.90 of cash and derivatives behind it. This 'net asset value' serves as a basis for trading during the following day.
2008-08-02 09:08:54
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Happymob Posts: 1735 Incept: 2007-08-03
West Virginia
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Quote:You left out one very important question. How do they work? Generally I mean. Since stock prices are based on bid/ask, then aren't the prices of the ETFs also based on bid/ask? If that's true, then that means they can't be based on the value of their underlying securities. They are priced at whatever someone is willing to pay for them. But if that's true, why do they seem to follow the moves of the underlying (either with or against)? Arbitrage keeps things in line. As with other index ETFs, certain parties can create or or destroy (through redemption) large units of shares. For ProShares, this occurs in 75,000 share units. Pricing of these units is based on the NAV of the ETF (which is reported daily). As a result, if the price of the ETF strays far from the NAV, an arbitrager will step in and profit off the discrepancy. This won't prevent temporary dislocations during the trading day, but should prevent significant discounts or premiums to NAV over multiple days. ---------- Anything from Missouri has a taint about it.
2008-08-11 14:07:15
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Rate_babe Posts: 399 Incept: 2007-08-03
Ga
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Bump because of all of the questions regarding how ETFs work and slippage. Thanks Foxy for doing this...and thanks to the poster in another thread who remembered this had already been addressed in Newbie!
2008-12-17 23:48:07
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Jfedak Posts: 4778 Incept: 2007-06-26
Down in Fraggle Rock
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One item to note- the staggered close time item no longer applies to Proshares ETFs: Investors in any ETF, including ProShares, should be aware of potential differences between daily net asset value (NAV) and closing price. ProShares NAVs are calculated using prices as of 4:00 PM Eastern Time, when equity markets close. Some ETFs calculate NAVs earlier in the day based on the time their benchmark prices are set (Fixed-Income ProShares NAVs are set at 3:00 PM when the bond market closes). Through October 7, 2008, ProShares traded until 4:15 PM ET, when the equity futures markets close. Beginning Wednesday, October 8, 2008, trading in ProShares ETFs on the NYSE Alternext U.S. (formerly the American Stock Exchange or Amex) will close at 4 p.m. ET rather than 4:15 p.m. ET (see separate announcement). http://www.proshares.com/funds/performan....
2008-12-18 00:05:50
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Wageslave Posts: 620 Incept: 2008-12-04
San Diego
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after following SRS very closely over the last few weeks, I have only one question: why the hell not just short IYR instead? What is the attraction of the inverse ETF? Is it the leverage? The "finite" downside? This is a serious question but quite possible a retarded one... I am a newb. My neophyte take on it is that an inverse ETF can never be perfect since to be perfect would have to admit the possibility of the price going negative... since that clearly *isn't* possible there must be a catch somewhere, and that catch manifests as slippage Yet I'm perplexed why people would complain about the slippage on one hand yet still opt to play the inverse ETF rather than short the underlying. So I suspect I must be missing something, or am just way way off base. Last modified:
2008-12-23 01:40:42 by wageslave
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Jfedak Posts: 4778 Incept: 2007-06-26
Down in Fraggle Rock
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> why the hell not just short IYR instead? 1) Tax deferred accounts where you can't short 2) If you catch the move correctly, the slippage works in your favor. 3) No time decay, no margin interest. There's no free lunch and under lower volatility conditions the slippage may actually be the lesser of the evils. And I also don't understand why people complain about the slippage yet continue to use these things.
2008-12-23 01:45:29
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Wageslave Posts: 620 Incept: 2008-12-04
San Diego
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thanks for the info jfedak I just made a small bet on SRS... here's hoping the slippage gods will be on my side today :)
2008-12-23 11:52:45
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Gmak Posts: 10176 Incept: 2007-07-27
Re-inventing the future at the speed of time.
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> why the hell not just short IYR instead? SHorting IYR leads to potential infinite losses. Buying an inverse fund limits your losses to the capital committed - just like a stock.
2008-12-23 12:29:02
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Dan721 Posts: 2185 Incept: 2007-08-23
Phoenix, AZ Online
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> SHorting IYR leads to potential infinite losses. Just in case the $DJUSRE index goes to infinity, right? Sorry, couldn't resist.
2008-12-23 15:57:26
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Luv2trade Posts: 5 Incept: 2008-04-18 NW
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Can an ETF conceivably zero out or there abouts without tracking the index if the manager/underwriter does a Bernie Madoff? So say the market goes into the toilet, and to everyone's shock, the inverse SDS goes into the toilet because we got scammed or somehow their underwriter couldn't find a counter party to pay off the underlying. Is this possible?
2009-04-03 02:14:51
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Oxfordrick Posts: 2685 Incept: 2007-07-09
san diego
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Yes.
2009-04-03 15:42:46
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