For those that don't know, SQQQ is a 3x leveraged inverse QQQ ETF. This means that if QQQ goes down 1% in a day, SQQQ goes up 3%. If QQQ goes up 2%, SQQQ goes down 6% that day, and so on. Buyers of SQQQ are generally bearish on NASDAQ or hedging.
One risk in buying shares of a leveraged (long or inverse) ETF is volatility drag, i.e. the difference between arithmetic and geometric returns. This is because these ETF products track daily performance of the underlying index, then “reset” the following day; they're not meant to be held long term. I'll outline a quick $100 example of volatility drag below, using SPY which monitors the S&P index, and UPRO, which is a 3x long S&P index.
| S&P Daily Performance | Value of $100 in SPY | Value of $100 in UPRO |
|---|---|---|
| 2% | $102 | $106 |
| -3% | $98.94 | $96.46 |
| 5% | $103.88 | $110.93 |
| -5% | $98.69 | $94.29 |
| 1% | $99.67 | $97.12 |
| 0.33% | $100.01 | $98.08 |
Even though the S&P and SPY have broken even and returned the original $100 investment, the levered UPRO product is underwater, due to volatility drag.
Are there ways to use this volatility drag to your advantage? For example and as the title of this post suggests, is short selling a leveraged ETF — preferably an inverse ETF, if you're of the opinion that the market will, at any point in the future, be higher than it is today — an effective way to capture this volatility drag? And when I say short selling, I mean actually borrowing the shares and selling them, as opposed to buying puts.
For reference, SQQQ is down over 98% over the past 5 years.
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