Capitalizing on Negativity: Tech Stocks

Private investors typically buy into the market when they perceive an upward trend in the market. However, there frequently arises a scenario wherein it is possible to make profits when the opposite is true. It is also possible to benefit when there is an adverse report about a company’s business practice is known or when there is a downward trend in the market.

Single-stock Short & Leveraged Exchange Traded Products (S&L ETPs) are practically purpose-built for such scenarios. A large number of these ETPs are built around some of the most heavily traded U.S. tech and finance stocks, which presently account for a quarter of the S&P 500 and nearly half of the Nasdaq 100.

Shorting on Adverse Reports

In early August, it was reported that Micron Technology Inc (MU) would not be supplying components to Huawei following a ban on Huawei phone sales in the United States. MU accounts for about 0.2% of the S&P 500 index (GSPC). While the index had largely recovered from the pandemic-induced downturn that began in mid-January by this time and was holding steady, MU suffered a fall on account of a loss of a crucial customer.

Being invested into a -1x MU ETP – which is equivalent to a -1x daily short position in the stock – on 11th of August (when the company lowered guidance) for a period of 10 trading days would have yielded a substantial benefit to the investor:

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While being invested into GSPC would have yielded a 2% gain in this period, being invested into the -1x MU ETP would have yielded almost 9%.

Given that MU had fallen far behind the performance of its parent index due to an adverse report at a time when the parent index was doing well, an investor might think that the chances of betting against a stock when the market is in a downturn isn’t favorable. This isn’t always the case.

Shorting on Market Downturn

In the opening days of September, all major indices had a substantial drop in value, following concerns that long-term growth outlooks on leading companies were far too optimistic to be realistic. AMD, a champion outperformer of the market since the pandemic’s effects were seen worldwide and which comprises about 0.3% of GSPC, was no exception. However, relative to the downward trend in the market, AMD’s fall was slightly more pronounced.

Being invested into a -1x AMD ETP from the 2nd of September for a period of 14 trading days would have yielded a substantial benefit to the investor:

While being invested into GSPC would have yielded a 7% loss in this period, being invested into the -1x AMD ETP would have yielded a gain of almost 14%.

A point of commonality in both cases is the fact that there was a “trend” in the patterns seen, i.e. both MU and AMD largely had a downward trajectory throughout the period under examination. The daily compounding formula within the ETPs heavily rewards (or penalizes) this aspect.

Daily Compounding of ETPs: A Primer

The daily “reset” feature of the ETP brings into effect a daily compounding effect that can often deliver more in gains than the leverage factor would imply.

For instance, consider a 2x Leveraged ETP in an upward trending market scenario with a 5% rise every day. Starting from Day Zero with an investment of 100 Euros, the 10-day performance would be as thus:

It can be seen that the daily compounding formula adds nearly 33% in gains over a 10-day period when compared to the expectations of a 2x investment in the underlying asset.

During days with choppy markets, oscillations around the mean would impact the product’s performance. Assuming a rise of 5% in a single day followed by a drop of 5% in the next would result in a 10-day performance as thus:

It can be seen that an expected shortfall of 2% was magnified to more than twice that amount because of the daily compounding formula.

However, another form of choppy market behavior is oscillation around a trending mean. In such a scenario, the product’s performance would converge close to the expectation of a 2x investment in the underlying asset. For instance, assuming a fall of 1.9% in a single day followed by a rise of 4% in the next would result in a 10-day performance as thus:

In this case, it can be seen that the product’s performance mirrors that of a 2x investment in the underlying effect.

From these illustrations, it can be summarized that when it comes to leveraged ETPs, “the trend is your friend”.

It is important to note that the scenarios depicted here show a trend extending over several days. However, in practice, it is not unusual to see a trend that lasts only a day or two. It is also possible to earn gains with this if an investor is tapped into market news and company reports. Thus, an investor with a keen eye on the market would be well-positioned to maximize gains whenever an outperformer is apparent for any period of time. In the event that this outperformance is seen in a stock with a downward trajectory, investing into -1x ETPs is a safer and cheaper means of making gains in tumultuous times.

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