Shorting is hard
Shorting assets is intrinsically difficult because
- while your position goes against you it gets bigger
- and when you win your position is getting smaller
Consider the impact of a $1mm fund that is designed to mimic a $1mm short in stock X.
-
X down 50% scenario
-
X up 50% scenario
Inverse ETFs and ETNs
The above dynamic is also how an inverse ETF or ETN work. The ETN must match the inverse return of a reference asset. So if all the AUM is exposed to the asset then we calculate the fund PositionSize/AUM.
In sum:
-
For inverse etfs to maintain a constant exposure in return space to their reference asset they must rebalance such that the dollar size of the underlying position is a fixed ratio to the AUM.
-
The inverse nature means that the AUM and position size are always moving in opposite directions requiring constant rebalance (negative gamma). This creates a downward drift to the product NAVs.
-
As the reference asset rallies, position size gets bigger and AUM drops due to losses. As reference asset falls, position size shrinks while AUM increase due to profits.
-
Redemptions can stabilize rebalance requirements in declines and exacerbate rebalance quantities in rallies as redemptions reduce shares outstanding and in turn AUM while in both cases triggering the fund’s need to buy the reference asset which again is stabilizing after declines but not after rallies. In other words, profit-taking is stabilizing while puking is de-stabilizing.
- I extend this explanation to levered funds here.
If you use options to hedge or invest, check out the moontower.ai option trading analytics platform
View Comments