Thursday, October 9, 2008

My Feeble (and Meek) Attempt to Short the S&P 500

The Securities and Exchange Commission took the unprecedented step of prohibiting short trading of 799 financial stocks for at least 30 days. It seems short traders are the scapegoats-of-the-moment but this ban expired at 12:01 a.m. this morning.

This reminded me of my feeble attempt to short the S&P 500 (in a very, very, VERY small way) between 2006-2008. It wasn't pretty.

(Note: Before you read on, please note my disclaimer on the sidebar.)

"Short Trader", get it? Never mind....

Why I Attempted to Short the Market
In 2006, I witnessed my SPDR S&P500 ETF (ticker: SPY) that I purchased in October 2001 go up, up and up. I was initially bummed that I didn't buy more between 2001-2003 when it was significantly cheaper.

Eventually, I became worried because I started seeing parallels and similarities (albeit superficial) with existing market conditions and conditions that led to the Great Depression: a President adverse to economic regulations (then Hoover, now Bush), yawning trade gaps, a seemingly endless stock-market boom, cheap money, and over-expansion of credit (then farms, now housing).

The ProFunds family of exchange-traded funds created a bunch of inverse ETFs that target individual economic sectors and broader categories in both the U.S. and abroad. ProShares Ultra Short S&P500 ETF (ticker: SDS) is designed to go up 2% for every 1% the S&P 500 average goes down.

In November 2006, I purchased 3 shares of SDS at $60.50/share (total ACB: $191.49 including $9.99 trading fee). I limited my investment to $200 since I was wary of the concept of “shorting”. I also couldn’t afford more. (He he.)

After I purchased SDS, I watched its value plummet all the way to $48.40/share in October 2007. At the time, I was prepared to lose it all and was relieved I only experimented with $200. But as you are all painfully aware, the market turned in October 2007 and the value of SDS started climbing.

I knew after trading fees were taken into consideration, my break-even price was $67.16/share. For reasons none other than wanting to make a small profit, I placed a limit order of $75/share.

Early 2008, SDS hit a little over $71/share (i.e., above my “break even” selling price) twice, but started going down again. I thought I missed my opportunity to break even and set my target price to $71/ share and later to $70/share.

I guess although I worried about a market crash, I never believed a serious one would materialize. And in my defense, clearly none of the so-called experts on CNBC did either. (Oh... how hindsight is 20-20....)

On 7/7/08, I sold SDS for $70/share.

SDS closed at $97.21/share yesterday. Gaaaaaaaa!!!!

What was my net profit on my $200 investment over a 21-month period?

$8.67 in dividends and a net sale of $8.52 for a net profit of $17.19 (or an equivalent return of 5% APY).

Lessons I’ve Learned
  • I Suck at Market Timing. Nuff said. :-(

  • But... I can make money by shorting the market using ETFs even if I can’t time the top and bottom exactly right. The volatility was a killer, though.

  • Shorting the market was a nerve-wracking and hard way to earn 5% APY. At the time that purchased SDS, ING savings was offering close to 5% APY. With such a small investment amount, I probably would have done just as well putting my money in an online savings account.

  • I’m "moderately risk averse" to "risk adverse". I set a target for myself at $75/share but lowered it when I thought I missed my opportunity to break even. Had I stuck to my guns, I would have met my target and made a pretty decent profit. But at the same time, I didn’t sell it in a panic when it went down to $48/share.

    So based upon this experiment, I’ve given myself a "moderately risk averse" to "risk adverse" grade in risk tolerance. But....

  • If I am speculating or market timing, invest in smaller increments. I was prepared to lose my entire SDS investment since I only invested $200. But had I invested $2,000, I wonder whether I would have sold the ETF in a panic? (I suspect, “yes”.) All the more reason why if I buy stocks or ETFs based upon market timing, I should keep the investment amounts small.

  • Limit trading fees up to 2% of investment amount. Since my investment amount was so tiny, TD Ameritrade’s $9.99/trade fees killed most of the profits I realized. But even if I limited the trading fees to 2%, my initial investment would have been 5 times bigger and my return would have been only twice as big. Perhaps when I invest in speculative stocks or ETFs, I am better off investing in smaller increments or, better yet, investing in a $0 fee/market trade account like Zecco.

  • Short ETFs are not a buy-and-hold investment vehicle, but rather a short-term trading investment. Since I'm more of a passive investor, there's more work and monitoring involved in trading short ETFs than I'd like. Also, if it's a short-term investment, it won’t provide capital gains tax advantages that buy-and-hold stocks have, so that's one less reason to invest in these short ETFs.

  • Short ETFs Have Inherent Credit Risks. I clearly had no idea what I was investing in other than what it purported to do. This article discusses the risks behind leveraged ETFs that's assets are based upon credit swap agreements.

  • I think what I'll do now is to take use the proceeds of my SDS sale and plunk it into SPY. Theoretically, when I turn a profit on SPY, I can use the proceeds to purchase SDS in the future. Or am I being too simplistic here? :-D