How to make money from market volatility

A friend recently wrote me about a strategy he heard for exploiting market volatility.  I get these questions sometimes because I’m in finance, and because I’m in finance let me be up front.  I’m not giving you financial advice here.  I’m not an advisor, I’m not competent, you should probably close this page now and burn your computer.  Past performance has no correllation with future performance, as everyone should have learned in, oh, 2008.

That said, let’s have a little fun with these ideas.  To paraphrase my pal’s email:

Apologies in advance for what I hope is a not-too-complicated financial question.  So you ever heard of something called volatility drag?  Something to do with how over time double- and triple-leveraged ETFs always lose money. I found an investment opportunity that uses this principle to make money.  The pitch I heard says that the strategy is sound and has data to back it up since the 90s.  I find it hard to believe that something that automatically mints you money (admittedly at a “watching paint dry” pace) exists, yet it seems so from what I can tell…

I hadn’t heard of volatility drag before but it was fun to learn about.  Under the fold:  Charts! Definitions! Sage Advice! Links to books!

The Strategy

The key to this strategy of making money off of Volatility Drag is to short a 3x leveraged Bull Index ETF 1 and a 3x leveraged Bear Index ETF 2.   These ETF’s should both be based around the same index.  What’s happening is your are making a negative bet on both ETFs.  Since your are short against both the bet that the index will rise and short against the bet that the index will fall you should be completely hedged against the effects of the index’s actual performance.  What you are isolating is the bet that both leveraged ETFs will suffer from volatility drag, which is common for them.

The idea is if the index goes from 100 to 110 and then back down to 100, owners of the index will have made no money, but owners of the leveraged ETFs will have actually lost more money due to the leverage.  The strategy is trying to make money by betting there will be volatility which will cause these losses.  Additionally, these ETFs charge management and administration fees, which means they don’t make exactly 3 times the performance of the index either way.  Wahey!  It’s a license to print money, right?

The platinum rule

If it seems too good to be true…

I’ve created a google spreadsheet to reflect a couple of different scenarios for this strategy.

A great scenario is if the price of the index bounces around the a steady price.  The example from above, illustrated:

In this scenario the index rises and falls and eventually ends up where it started. Click image for a detailed spreadsheet. GL = Gain or Loss

I noticed a couple of things.  If you have steady anything, this strategy is a bit of a whiff.  As long as the index price is swinging about, this is a great strategy.  It thrives on change and uncertainty and swings in the market.

If the index is steadily declining, you’ll see this make just a bit more than the underlying index.

The volatility play loses money, but at a slower rate than the index. Click the image for a detailed spreadsheet.

If the index is steadily increasing, you’re totally fucked.  See the sheet called growth.

Steady growth makes the strategy tank.

For giggles (and something more like a real market), check out the sheet named Random +- 10%.  That’s like a regular market.  If you’ve got a google docs account you can copy the spreadsheet and just type in there to generate different random markets.   Type anything in the space I provided and you’ll see a whole new scenario generated.  Some will be favor the index, some the volatility strategy.

The Baseline

So, just like any strategy, what you are doing is making a bet.  It’s important if you’re making a bet to know the exact bet you’re making and all the terms.  Here, what you’re betting on is that there will be high volatility.  Get in this strategy if you know something the other guy doesn’t, if you predict there’s going to be high volatility.

OK – say you think there’s going to be high volatility…

I’m not sure how you, someone poor enough to be reading my free blog, get in this strategy.

To execute it you need to be able to short stocks.  That means borrowing stock to sell it.  The opportunity to short costs money (it’s part of my day job’s revenue stream).  You are exposed to being forced to buy in before your strategy makes money because shorting exposes you to unlimited losses.

Some Resources

The best, and so far most entertaining, book I can recommend on stock market investing is “A Random Walk Down Wall Street“.  It’s in the liberry, go get it.  Sam highly recommends the book “Smart Couples Finish Rich.”   A good blog that I think offers valuable free tips that are very sound is “I will teach you to be rich“.  Once you’ve read any book about investing, anything at all, you should check out the amazing book “The Black Swan: The Impact of the Highly Improbable.”  It was about the end of 2008 and it was written in 2007.

That spreadsheet was fun to make, I hope you checked it out.  This took way more time than I intended, please let me know if there’s ways for it to be clear.  If folks like this kind of look into the world of finance, let me know if there are other things you’ve run into, especially if it is a “sure money maker.”

  1. This bets that the underlying index will rise in value and uses leverage to get triple the performance of just buying the Index.   (back)
  2. This bets that the underlying index will fall in value and uses leverage to get triple the performance of just shorting the Index.   (back)

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