Wednesday, April 23, 2008

Ultra long/short possibilities

Over the last 5 trading days (including Friday's big up day) the S&P is up 1.12% - it is doing a good job in hanging onto the bulk of last Friday's gains.

Zooming out, the S&P is still trading in the 132-139 range. I am trying to stay poised for when the market does breakout – one way or another. I still believe that there is a bias to the upside. I base this on the market’s persistent neutral to positive reactions to negative news.

One of the strategies I have been considering has been to buy ultra long ETF options on either the Nasdaq (QLD) or S&P (SSO). Basically the SSO is designed to double the returns of the S&P 500 and the QLD is designed to double the returns of the Nasdaq.

So if you’re really bullish on the broad market, for example, and feel a breakout to the upside is coming, you might consider buying SSO instead of SPY to maximize your return. Remember that SSO is designed to double the return...positive or negative.

Theoretically, if SPX moved 5%, SSO would move 10%.

Here are a couple of things I wanted to initially test: Is the ratio, with regards to returns really 2 to 1, for SPX, SSO? How about SPY to SSO? Or QQQQ to QLD? Can an options strategy be applied to these ultra-long ETFs?

Results here: .XLS

Results summary:

SPX:SPY return ratio: 0.95 --> expected value 1

SPY:SSO return ratio: 1.84 --> expected value 2

SPX:SSO return ratio: 1.11 --> expected value 1

QLD:QQQQ return ratio: 1.96 --> expected value 2

For me this turned out to be just an exercise in futility. If you were, however, considering implementing some sort of leveraged hedge strategy, the 0.16 (2.00 - 1.84) could be significant. Let's move on.

In terms of trading options on these ultra long ETFs, there are a couple things worth noting. First, these ultra longs are relatively new. In this case it means that the bid/ask spreads on SSO and QLD can be .50 apart, especially in the outer months. There's two problems with this: foremost slippage, but also if you need to adjust or liquidate your position, you might not get filled.

I wouldn't recommend, in terms of options, being on the selling side of these products. Maybe when they become more popular, and they will, spreads will be tighter and volume will pick up in the strikes that are not just ATM. Keep in mind that there are inverse 2x ETFs as well. Further, you could consider buying puts on SDS (2x inverseETF) instead of buying calls on SSO - of course, the volume and spreads will even be worse.


I will come up with some creative ways to use these ultra longs/shorts as they relate to option strategies and share them when available. My initial thought is that you could hedge a long position with these ultra shorts by buying half as many, hence preserving some of your capital outlay. Not as simple as it sounds I'm sure so I'll try to quantify it with some paper traded results.









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