June 28th, 2008

How Do UltraShort ETF’s Work?

A reader named Ram, wrote “Ultrashort ETF’s now? Aren’t we pretty close to an intermediate term low?” I never quite thought about what expectations I should have of UltraShort ETF’s. I just believed they go up when the market goes down.

But Ram’s questions got me thinking. What is the relationship between the ETF’s and their underlying indexes. I’ve went out on a limb projecting that the S&P 500 Index will drop but never examined what that meant for SDS, it’s associated Ultrashort ETF? And what about the Nasdaq Composite and its QID, or the Russell 2000 and TWM?

One way to understand the relationship (for stock chartists, that is) is graphically. So I went back to the data since the ETF’s launch dates and created the following charts and tables.

  • S&P 500 (SDS)
  • Nasdaq Composite (QID)

    • Russell 2000 (TWM)

    Granted, my “projections” are based on my the assumption that the S&P 500 will breach its lower boundary support and continue down to 1150. Should that happen, the other indexes indicate similar declines which, not so coincidentally, are in the same percentage ballpark range.

    I’ve tried several times to understand the mechanics of UltraShort ETF’s but the best I could do is infer that the issuer (State Street) makes a market in them, will make their income by someday redeeming them at markedly lower prices since they theoretically decrease in value by about 10%/yr. over the long-run and, perhaps, after the market has gone up considerably, the ETF’s will be subject to reverse splits to raise them back to tradable prices. While they do increase in value as the market declines, it is of no concern to the issuer since they have nothing to do except maintain the market. All that happens is that holders make profits by trading back and forth to eachother.

    There’s an underlying relationship between the Index and the ETF but the actual price might vary from it based on supply and demand (and augmented by State Street issuing more or redeeming some in their market making activity). The premium or discount moves something like the VIX. When the market increases, demand for the ETF’s decline; when the market declines, demand increases.

    So, thanks for asking the question, Ram It forced me to do some technical and charting research to arrive at some expectations of the profit opportunity in a market decline (or risk in a positive reversal) in these UltraShort ETF’s.

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