Thursday, February 26, 2009

UPDATED: Voltron's New Strategy

Voltron says: Suppose you believe (as I do) that commercial real estate is going to collapse. Let's explore some different ways to profit from that thesis (in order of complexity) and discuss some of the pros and cons of each strategy.

Short Real Estate Index (IYR): Like all short positions, you have theoretically unlimited liability (suppose IYR goes to the moon) and limited profit potential (IYR cannot go below zero). For every dollar of capital you have, you'll most likely be able to short two dollars worth of IYR so your maximum leverage is 2 to 1.

Buy Put Option on Real Estate Index (IYR): Now you have limited liability (the option cost) and limited potential (again, IYR cannot go below zero). Leverage ratios are typically 4 or 5 to 1. Options expire, so you need to be right on the direction AND the timing. This property of all options is called "Time Dependence".

Buy UltraShort Real Estate Index (SRS): If you are unsure of the timing, the ultra short ETF may seem to be just the ticket. You have limited liability (because you simply buy the ETF), and potentially unlimited profit potential (assuming the price asymptotically approaches zero). You also get two times leverage. The problems with SRS, however, are manyfold. Suppose the you've made a lot of money in the ETF and then suddenly the IYR moves up 49% in one day - SRS would be down double: 98%. You would be unlikely to recover from this loss no matter low the IYR goes subsequently. This property is called "path dependence" and it also makes it difficult to derive a target price for SRS based on a target for IYR. For a more detailed explanation read this.

If you chart the Ultra Short Real Estate ETF (SRS) and it's evil twin, the Ultra Real Estate ETF (URE), you'll see that actually both drift down together and are both negative at times. This is due to the path dependence discussed above and is called "Volatility Drag".

you therefore may reasonably consider the following trade to make the volatility drag work in your favor:

Short Ultra Real Estate Index (URE): You're now taking advantage of the volatility drag; however, since it's a short position, you have unlimited liability.

Buy URE Put Option on Ultra Real Estate Index (URE): You're stll taking advantage of the volatility drag and since it's an option, you have limited liability. Hindsight being 20/20 buying a URE put would have been the optimum strategy. URE puts are currently too expensive to make this worthwhile; however, I am currently implementing this strategy for Oil (up), Gold (up) and S&P500 (down).

Here's a chart summarizing the strategies:

RiskRewardLeverageTime DependencePath DependenceVolatility Drag
Short IYRUnlimitedLimitedUp to DoubleNoNoNone
Buy IYR PutLimitedLimitedHighYesNoNone
Buy SRSLimitedUnlimitedDoubleNoYesBad
Short UREUnlimitedLimitedDoubleNoYesGood
Buy SRS CallLimitedUnlimitedVery HighYesYesBad
Buy URE PutLimitedLimitedVery HighYesYesGood

No comments: