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Dec 12, 2018

Backtesting Options on Leveraged ETFs

By:Sage Anderson

Exchange-Traded Funds (ETFs) have exploded in popularity in recent years, and because of that, so too have the number of choices in this niche of the financial markets. The best-known of this group is without question the SPY, which also happens to the be the oldest ETF (the first-ever created).

At their core, ETFs are exchange-traded, marketable securities that own underlying assets (shares of stock, bonds, commodities, foreign currencies, precious metals, futures, etc...) and divide ownership of these assets into shares.

While many ETFs are designed to track the returns of an index (like SPY attempts to track the S&P 500), others can be much more narrow in scope, tracking one subsector of the market (technology, for example) or even one particular commodity (lithium, for example).

Likewise, there are also ETFs that are designed to return greater multiples than the index or asset they track. These are called leveraged ETFs, and can be built as both bull (long) or bear (short) investment vehicles.

For example, the three ETFs listed below are designed to mimic the returns of the S&P 500, though at different multiples:

  • SPY: 1x

  • SSO: 2x (bull)

  • UPRO: 3x (bull)

In order to produce the targeted returns, leveraged ETFs like SSO and UPRO utilize financial engineering techniques that call for rebalancing and reindexing as well as holdings in equity swaps and derivatives. Market participants that are considering leveraged ETFs should therefore conduct appropriate research to ensure a given product matches their risk profile before entering such a position.

If you are looking to learn more about leveraged ETFs, a recent episode of Market Measures is worth a few moments of your time. Like other ETFs, leveraged ETFs typically list associated options, and therefore may at times catch the attention of volatility traders.

On this installment of Market Measures, the hosts provide additional perspective on the options of leveraged ETFs by backtesting a simple trading strategy, and comparing the results to a "normal" ETF. In this study, the SSO and UPRO options were compared to those of SPY.

At a high level, the analysis conducted by the Market Measures team sought to understand how short strangles performed in the three ETFs over time, and backtested this question accordingly.

While the precise parameters of the study can be reviewed on the complete episode, the information below highlights the relative performance of short 16-delta strangles in the three ETFs using data from 2010 to present:

As you can see in the above information, the backtests revealed that over the period examined, SPY produced the highest win rate, and highest return on capital. It should be noted that leveraged ETFs have higher margin (i.e. capital) requirements due to their riskier nature.

Digging a little deeper into the historical data, the Market Measures team discovered that the leveraged ETFs actually tended to move more than their targeted multiples of 2x and 3x the S&P 500. It's this added realized volatility that likely detracts from their net performance when compared to SPY, in terms of short premium performance.

The graphic below illustrates how the SSO and UPRO on average experienced higher standard deviations than expected. Based on the average standard deviation of the SPY (+/- 4.2%), the SSO and UPRO should possess standard deviations of respectively +/- 8.4% and +/- 12.6%, but in actuality it's even higher:

The above information helps explain why the options strategies backtested in SSO and UPRO produced suboptimal results as compared to the SPY.

This exercise also reinforces the notion that any foray into trading the options of leveraged ETFs should be predicated by extensive research, observation, and likely even mock trading to ensure that potential risks are fully understood and accepted prior to trade entry.

The same careful approach should also be taken by anyone considering simple long or short positions in the underlying stock of such products (leveraged and inverse ETFs) as well.

We hope you'll take the time to review the complete episode of Market Measures focusing on leveraged ETFs when your schedule allows.

If you have any questions about trading ETFs (leveraged or otherwise), we hope you’ll leave a message in the space below, or reach out directly to @tastytrade on Twitter or at your convenience.

Thanks for reading!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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