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If I own an ETF (say based on the S&P 500) and also a short on a correlated index (e.g. SH), does that mean I am guaranteed to win in either extreme market condition? I simply sell the one that is high, hold the one that is low, use the profit to buy more of the low, then wait for the market to invert, and simply repeat the whole process?

Assuming you put the limit orders in for both, you're guaranteed to keep making money aren't you? Or am I misunderstanding what 2 inverted ETFs can do?

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I must be missing something. This sounds like you wish to be long and short the same index. Whatever it was you suggested, if it were that easy, those smarter than you or I would already be doing it, with far more money. –  JoeTaxpayer Apr 18 '12 at 4:11
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Note that "guaranteed profit" and "profit in extreme market conditions" are two radically different things. –  ChrisInEdmonton Apr 18 '12 at 14:57

4 Answers 4

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Depends on your time scale, but generally, I don't think it would work. What you'd really be betting on in this case is mean-reversal, which does not hold true in the equity universe (atleast not in the long run). If you look at the historical prices of the S&P, you'll notice it increases in terms of absolute dollar value. On the short term, however, if you feel the market has significantly undervalued or overvalued a security, then mean-reversal might be a reasonable bet to make.

In that scenario, however, it seems to me that you are really looking for a volatility trade, in which case you might want to consider a straddle position using options. Here, the bet you'd be making is that the price at expiration will be inside a certain band (or outside the band, depending on your position).

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Also, if you're shorting an index (directly or otherwise) it's not a free operation like owning an index is; you've borrowed stock from someone and are going to have to pay for it. And then there will be transaction fees too. (I call owning an index "free" and neglect small ETF expense ratios which are nothing next to short interest.) –  fennec Apr 18 '12 at 17:53
    
Thanks for all the replies. What I also have learnt since posting this question is that after the first major spike, the inverse ETF no longer mirrors the ETF. I'm not exactly sure why - but I think it's something to do with put options having an expiry date. –  Sridhar-Sarnobat Apr 25 '12 at 3:17

Depending on the Price of the ETF and the hedging you may well simply be guaranteed to make a small loss.

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I think what you really want to look into is put options. You can essentially replicate the same thing, without worrying about margin calls. Check out this site http://www.fundamentalfinance.com/options/options-basic-charts.php a quick glance seems to show it to be pretty good.

The way you would limit downside risk is to buy a put option, allowing you to sell anytime within the next n months for the current price (assuming american). This will allow you to limit downside risk, however, potential profits do go down due to fees as another answer suggests this could be cost prohibitive. This type of strategy is also known as a "protective put". http://www.optionseducation.org/strategies_advanced_concepts/strategies/protective_put.html

If you wanted to be more refined you could use Ak's bands, although you have to be looking for that specific outcome. Also due to complexity, this can become a taxing (in terms of time invested) and risky (if you are wrong) investment.

Either way I think you need to study payoff curves a little more.

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Hedge means protecting downside, and that generally comes at a cost that translates into less upside. Amount of downside you are protecting is directly co-related to the quality of your hedge.

For your example to work, the market should invert while you are still solvent; remember

Markets can remain irrational longer than you can remain solvent

And yes, there is nothing guaranteed in life - except tax and death of-course!

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