SPXU: Harnessing Volatility in The S&P 500, to Short the Market With a Three Times Inverse ETF

Fed Chairman’s Powell reassuring statement on Tuesday and inflation figures for 2021 being in line with estimates on Wednesday seem to have appeased bearish sentiments resulting in the S&P 500 rising.

However, there are many different elements that are likely to impact stocks, such as the continuation of the economic recovery, corporate earnings, inflation, supply chain concerns as well as the likelihood of the Omicron variant stressing hospital services. These should result in continued volatility episodes as seen in the S&P 500 ETF Trust ETF (SPY) which tracks the S&P 500 index.

Source: fxempire.com

In such conditions, people are normally risk-averse, or avoid trading and prefer to wait for some relative calm before looking at stocks. This is the case for most of us, but, there is another option which is to trade the volatility using a tool like the ProShares UltraPro Short S&P500 (SPXU) which inversely tracks S&P 500 at -3 times its daily performance.

This calls for enticing gains as a 5% fall in the SPY can “theoretically” bring you 15% gains, but my own experience has taught me that just putting money in the SPXU at the first sign of a market downturn is unproductive. Instead, I use the chart below which shows the performance of the ProShares ETF from January 2020 to date. It includes the spring 2020 crash subsequent to the World Health Organization declaring Covid to be a pandemic.

Investors will notice that I have calculated the amplitude obtained by subtracting SPXU’s daily low from the daily high. Then I converted the resulting value as a percentage that more vividly represents the volatility induced in the ProShares ETF’s through its daily variations.

Here, the March (spring) 2020 crash resulted in gains of over 30% but this was achieved over a period of many weeks. The second noteworthy point is the above-10% differences which, after occurring four times from June 2020 to February 2021, ceased till November last year.

Source: Chart built by author with data from finance.yahoo.com

Then, came the December 1 market downturn, induced mostly by tech stock aversion, as investors increasingly rotated into value names. To be realistic, this high-volatility episode may prove to be a lone occurrence, but forthcoming events should constitute catalysts for further fluctuations.

First, the earnings season is to be kicked off by banks on Friday this week, and with investors having already placed a lot of expectations on the financial sector as the main beneficiary of the economic recovery and this, thanks to rising interest rates allowing an increase in net interest margins on loans.

This expectation may suffer if megabanks like JPMorgan Chase (JPM) Citigroup (C) and Wells Fargo (WFC) fail to provide any upside surprises in their fourth-quarter earnings reports. Others like the Bank of America (BAC) and Morgan and Stanley (MS) will follow suit. Then, it will be the turn of the big techs with Microsoft (MSFT) on Jan 25 and Apple (APPL) on Jan 29, with analysts being keen to observe for any effects caused by the semiconductor supply crunch.

Second, there is the VIX (Volatility indicator) also referred to as the “index of fear” whose methodology is based on the stocks forming part of the S&P 500. Higher is the VIX, more are volatility risks, and from its high of 35, the indicator is currently at around 18. Given that this figure is far from the VIX’s above- 85 spike during the spring 2020 market crash, a major downside does not seem imminent, but a near-20 value signifies that volatility is persisting.

This signifies that we are in an environment conducive for gains through the SPXU.

Pursing on a cautionary note, I deliberately used the word theoretically above when mentioning possible gains with the SPXU. In this case, a 5% loss in the SPY will not convert into a 15% gain in the SPXU as some percentage points will be lost due to the compounding effect which is a specific feature of highly leveraged ETFs. The net gain will ultimately depend on the degree of fluctuations (volatility) during the trading period. This discrepancy is evident in the one-week performance chart below where a -1.39% loss of the SPY has not translated into a 4.17% (1.39 x 3) gain in the SPXU, but only a 4.15% gain.

Source: Trading View

Considering the long term, due to the leverage, the ProShares fund has delivered a 55% loss and thus, a buy-and-hold strategy is to be avoided, and it is preferable to use this market shorting tool for the least amount of time possible, preferably one day as per the prospectus. This said I have held it for up to five days after gaining some experience selling it at a loss due to the unpredictability of the market. Looking at portfolio protection, some investors also use the SPXU as a hedging tool to gain from a falling S&P 500. Thus, by hedging, these investors hold on to their stocks instead of passively selling them and taking profit in the expectation of an elusive market crash.

Finally, my advice is to wait for the VIX to go above 20 before placing your bet, and this should happen this week or the next. Also, patience, rigorous monitoring and being prepared to exit with a loss are key ingredients for shorting the market.

Disclosure: I/We are long Apple. This is an investment thesis and is intended for informational purposes. Investors are kindly requested to do additional research before investing.