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Exploiting ETF Decay

Based on a theory published here: Post-2008 Wealth Creation Guide

I decided to write a backtest to play with it. Thought I would share it for others to play with (all 13 lines of it :D ).

Clone Algorithm
94
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Backtest from to with initial capital
Total Returns
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Alpha
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Beta
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Sharpe
--
Sortino
--
Max Drawdown
--
Benchmark Returns
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Volatility
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Returns 1 Month 3 Month 6 Month 12 Month
Alpha 1 Month 3 Month 6 Month 12 Month
Beta 1 Month 3 Month 6 Month 12 Month
Sharpe 1 Month 3 Month 6 Month 12 Month
Sortino 1 Month 3 Month 6 Month 12 Month
Volatility 1 Month 3 Month 6 Month 12 Month
Max Drawdown 1 Month 3 Month 6 Month 12 Month
# Backtest ID: 57b11244b8d99a0ff9c480a1
There was a runtime error.
16 responses

Nice. Excuse my ignorance, but why do you rebalance every third month?

Rebalance every quarter - that's the principle. Although I don't think it matters much, you could just as well rebalance monthly.

Mohammad, really interesting. Thanks for posting!

Any thoughts on how to model the negative rebate that you'll have to pay on these?

Seems the fee rate for these stocks is in the 3.5-3.8%, and the rebate is ~ negative 3.4%

I dont know of a way to model the interest you will be paying for the shorts - I think this might be near impossible unless you got historic short rates from IB and factored that into the algo.

As the article suggests, a better way to approach this might be to use a synthetic short using options, to avoid the interest on shorts.

As a test, I put on synthetic shorts for SPXU and TMV in my IB paper account. The bid/ask spread on the options is rather large (especially long term) showing an instant paper loss, but we'll see how it behaves. Given the slippage, I don't think you could re-balance very often if using the synthetic short approach.

Might not be necessary in any case.

Thank you, Mohammad, for this very interesting contribution and for publishing your algorithm.

Inspired by your post I went and read a bit more about the strategy, and the way I understand it, the usual approach is to use leveraged ETFs that are one long and one short on the same underlying. This seems not to be the case about SPXU and TMV, which have different underlyings. But then again, I may be badly mistaken. In any case, please illuminate me. Many thanks!

In running the backtest, it never seems to sell what it is holding. It only buys more(or in this case opens more short positions)?

This will put your way over leveraged in real world trading.

Shouldn't the algorithm sell the current holdings and then open new positions every quarter?

@Tim - this algo doesnt go long and short on the same underlying, so it is not hedged.

The theory of this algo is that bonds and stocks usually behave inversely to each other, so if one is going up, the other should be going down. As such, they act as a hedge to each other. Personally I dont agree with this theory as I believe bonds are much more strongly tied to interest rates than stock markets, but since we dont have enough data to backtest farther into history, it is hard to test with this algo.

@Tyler - if you look at the transactions, it does both buy and sell. The goal of the algo is to keep the 50/50 balance, so all it does is rebalance.

Just posing a question.

instead of worrying about borrowing to short - why not just go long their inverse?

The whole premise is that the ETF will decay over time. Since you know it is going to decay, you want to short, not long.

I'm new to short selling, so I've been reading up on it.

Seems like a black-swan event could potentially wreck you if you were to use this strategy. How much could somebody be on the hook for in an absolute worst case scenario?

Well selling short means that the theoretical loss is potentially infinite.

The real question is... will there be an event which would cause SPXU and TMV to both spike? Although I think that is unlikely, I think there may be a black swan event that would cause SPXU to spike, and TMV to just move a little. In this scenario, you would be looking at a large loss - potentially greater than your initial investment.

Is anyone trading the synthetic short with this? I find the article at the top confusing as all of my research says to buy a put at the closest strike price to what it is currently trading and to sell a call at the same strike price to create a synthetic short.

  1. The article bought a put and sold a call almost 8% more than what SPXU was trading at. There is also a mention of trading a collar, which is completely different than this?
  2. How far out would you buy the put and sell the call if you are rebalancing every quarter.
  3. How would you rebalance every quarter when the spread is ~$1

I wish it was easier to just short these leveraged ETFs

Added Optimize API and changed fixage/comissions to contest rules even though leveraged etfs are prohibited. Still very impressive results.

Clone Algorithm
28
Loading...
Backtest from to with initial capital
Total Returns
--
Alpha
--
Beta
--
Sharpe
--
Sortino
--
Max Drawdown
--
Benchmark Returns
--
Volatility
--
Returns 1 Month 3 Month 6 Month 12 Month
Alpha 1 Month 3 Month 6 Month 12 Month
Beta 1 Month 3 Month 6 Month 12 Month
Sharpe 1 Month 3 Month 6 Month 12 Month
Sortino 1 Month 3 Month 6 Month 12 Month
Volatility 1 Month 3 Month 6 Month 12 Month
Max Drawdown 1 Month 3 Month 6 Month 12 Month
# Backtest ID: 59b740ca9be4dc51012a3e66
There was a runtime error.

So what happens to this in an '08 scenario? Total wipeout?

Great strategy for a bull market, but it's gotta end sometime.

I'm revisiting this strategy post the sell off last week. How would one "rebalance" their option position.

Also, how far our would you buy the options - would you buy them to expire each quarter and rebalance that way?