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Abstract Dynamics

Last Build Date: Sat, 09 May 2009 23:37:40 -0500

Copyright: Copyright 2014

ETF FAIL: Understanding Time/Volatility Decay in Short and Leveraged ETFS

Sat, 09 May 2009 23:37:40 -0500

There is a crack epidemic on the stock market. It trades by a variety of street names, FAZ, FAS, SRS, TZA & QID being just a few. Like crack cocaine these vehicles promise fast and stunning highs, one small hit can take you to the top. Occasionally they even succeed, but like crack cocaine these vehicles are doomed to collapse, each successive hit providing ever diminishing returns, lower lows that an addict believes they can only escape from via another hit. Unlike crack there is nothing illegal about these things, they are short and/or leveraged ETFs. Exchange Traded Funds designed to replicate the effects of shorting various industries and trading with high amounts of leverage like the big boys do. ETFs are a very new concept to finance, they are basically mutual fund like entities that trade on the stock market, making them more liquid and more accessible to investors than mutual funds. They've been around for about two decades, but it's only in the last few years that they have really taken off in big numbers, with "innovative" short (aka bear) and 2x or 3x leveraged ETFs popping up left and right. Take a look at a chart for FAZ, the 3x Short Financial Industry ETF and look at the volume indicator on the bottom to get a sense how interesting in these things has exploded. In 2008 leveraged bear etfs like FAZ were tickets to riches, as the stock market crashed they erupted in value, possibly making a few clever operators insanely rich. But that initial success quickly turned nasty. These ETFs are all flawed to the core, they are designed in a way that they decay over time, their values fluctuate up in down, but the overall tend is mathematically almost guaranteed to be down. The easiest way to see this flaw is the look at chart of a leveraged Bull and Bear pair over time. FAZ is a 3x Bear, it is designed to go up when financial industry stocks go down, and to return 3 times more than the value that those stocks go down. FAS is the 3x Bull counterpart, it is designed to go up when the financials go up, and to go up 3 times faster on a daily basis. One would logically expect these two ETFs to cancel each other out, one goes up 3x when the other goes down 3x, so over time the net result should be zero. Yet if one looks at chart of these two mapped out over the past 6 months a very different picture is drawn. FAZ is down 94%, and FAS somehow is down too, by an almost as nasty 75%. Both are decaying rapidly taking their holders down to the bottom all because of a nasty mathematical quirk (or less generously flaw) in their design. What's happening is volatility decay, these ETFs all lose value when the stock indexes they track are fluctuating up and down. The key to understanding why is a very basic mathematical fact relating to the way these ETFs are designed to reflect the daily percent changes of the parts of the stock market. The problem is that percents going up and percents going down don't always sync up, but instead have a distinct downward trend. This is easiest to see by looking at a 3x leveraged ETF. Lets call this ETF BSBS, and assume it's positively tracking the Bull Shit Index. When it starts both the index and BSBS are valued at 100. The next day the index goes up by 25% to 125. Now BSBS is designed to return 3 times that percentage or 75% so it goes up to 175. For a day at least it's a great investment vehicle. Now suppose the next day the index falls back down to earth, a 20% decline back down to 100. Well BSBS is now designed to go down 3x that or 60%. Now 60% of 175 is 105, a monstrous decline. The BSBS ETF is now all the way down to 70, while the index is still hanging in at 100. That's it in an essence, these things rise fast, but they fall even faster. It's that simple and that toxic. The exact same thing is even truer with Bear ETFs. A non leveraged Bull ETF will actually have no volatility decay (although there are other smaller decays in their design). But the corresponding non leveraged Bear ETF will have a decay. Say you have a Bear ETP called UUPP des[...]

The Tariff

Sun, 18 Jan 2009 13:26:10 -0500

So we are deep into a recession, with no particular end in sight. Obama has promised to jack up the governments debt already. The trade deficit is still stratosphere high. Tax cuts promised too, unemployment rising fast, and economists are worrying about deflation.

Something in those numbers doesn't add up, does it?

Right now the whole situation is staying afloat based on the fact that the US government can borrow money in a currency it also funnily enough can print itself. As long as they can keep doing that, deficits don't mean jack, we can get all the money it's shipping away back for the price of some paper and ink.

Then again the government has lowered interest rates to practically zero, how long will it be able to borrow money at those rates?

Raising rates means putting a squeeze on all the individuals and companies in the US currently deep in debt. Raising taxes to pay debts just sucks money out of the US economy. Maybe the economy just does a 180 and exports pick up, revenues rise and things correct. Or maybe the US Government really can borrow forever for free. Neither seems particularly likely though.

Things continue on a course like we see today and I have to wonder if we are charging fast towards the end of the free trade era. The government needs revenue, and they want to do it with taking that money out of the country's economy. The country needs jobs, the government is worried about deflation and the economy is net bleeding billions due to it's trade deficit. I'm not really one to predict the future, but are we looking at a big time return of the tariff?

edit (05/10/2009): Well a 100+ days past this entry and it's clear that tariffs are not high on the agenda, yet. It's all about the Federal government borrowing money and printing dollars and likely will be until either recovery or collapse of that system let's see how this plays out...

Outlier Tailored Performance

Thu, 13 Nov 2008 18:52:36 -0500


Outlier is my new venture. Probably find me writing a bit more there then here for a while. Outlier makes tailored performance clothing for cycling in the city. SItes filled with info so take a look. Smart shoppers probably want to head here or here to catch a discount...


The World For

Thu, 23 Oct 2008 19:19:21 -0500

Seth Carnes, my old friend and former partner in both One Infinity and 47 has a brand new project that allows the whole world to get in on this US presidential election. Check it out below and don't forget to vote.

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Market to Marks

Wed, 01 Oct 2008 00:28:08 -0500

Hidden amongst this current financial crisis is a nasty little truth about neoclassical economics the hits to the core. This is the idea that economic objects should have one "market price" or equilibrium. The truth that lies in plain site is that this just isn't true. A bottle of orange juice might be a dollar in one shop, a buck fifty down the road and seventy five cents across town. There is a whole bullshit loads of talking around the clear fact of how this undercuts the very basics of economic theory. And there are also massive systems in place at stock and commodities exchanges, explicitly design to produce something as close to equilibrium prices as can be generated. But under this age's crisis all that cover falls clearly apart.

The issue is what is known as "mark to market", a system by which firms need to value their investments for accounting purposes based on the present market value of each financial object. And it needs to be done daily. In stable yet liquid market conditions this is generally a good thing, it promotes transparency and prevents firms from hiding bad investments behind dubious accounting practices.

However the system has fallen clean apart over the course of 2008. As firms get more and more risk adverse the liquidity for many investment vehicles has evaporated. The market value has plunged to zero, no one is out there that is willing to risk buying these things. Standard economic theory would have it that these things with zero market value are then financially worthless. But the fact is that they actually stand to return quite a bit of money over their lifespan. They have no market value in a risk adverse environment but have plenty of value to the firms holding them.

The mark to market rules have played at least some role in worsening the current financial crisis by exaggerating the losses in many firms. They are forced to report huge losses as the market value hits zero for their illiquid assets, yet these same assets will return at least some income over their lifespan. The SEC is currently "loosen" these rules, but just how so remains a bit unclear. Ultimately I can be almost sure they won't address the core issue though.

What really needs to happen is for economics to give up it's insistence on the idea of equilibrium pricing and acknowledge that markets can happily support a multitude of prices for any given object at any given time. It's no easy task because it essentially means scrapping a mass of economic theory and starting over from close to scratch. No easy task there, to say the least. But for a discipline that still can't answer Thorstein Veblen's 110 year old question of "Why is Economics Not an Evolutionary Science?" it's a completely essential step.

The Spam King of Nigeria and Other Stories

Fri, 08 Feb 2008 22:41:01 -0500

Ordinarily I'd just post a like like this one on the side bar but :apophenia: a google horror story: what happens when you are disappeared is a crazy one. A couple years ago I did a scenario planning session that revolved around spammers hacking email accounts and impersonating people from your past. That's not exactly the story, but as "phishing" attacks get more and more sophisticated it's heading in that direction. And google's centralization of power sure is going to help in that process.

I've been terrified of google for a long while now for exactly these reasons. They just have too much power, too much information centralized in one location. (Or really centralized and multiplied across multiple locations) It doesn't really matter if google is good or evil, or both because that much info placed into one interface and virtual location ensures that bad shit is going to happen. You know like your entire digital identity being hijacked, used abused and then sold off as scrap to the highest bidders. Add in google's god awful customer service (and a company with engineers at the helm is almost always ensured bad customer service) and the you've got an awfully frightening entity.

True Conservatives

Thu, 07 Feb 2008 05:42:18 -0500

When uber right wing pundit Ann Coulter stated she'd campaign for Hillary Clinton over John McCain I was quick to write it off as a play for attention from one of the worst media whores in the business. Coulter loves to take extreme positions and run with them as far as possible. But the continued hate for John McCain spewing from the likes of Coulter, Rush Limbaugh and James Dobson is fascinating.

Politically I've never gotten McCain's rep for being centrist. He's a right wing warmonger in my book and his vote record is deeply right wing. But when Coulter says Hillary is more conservative than McCain, she's not really talking policy and shockingly enough she's actually right. Policy wise of course Clinton is moderate but far to the left of McCain. But personality wise, Clinton couldn't be more conservative.

At it's core conservatism as a philosophy is about maintaining the status quo, keeping the power structure intact. Clinton has climbed her way to the top of US politics and she has no interest in sharing that power or letting it slip away. McCain on the other hand has spent years cultivating an image as a maverick, a man who will think for himself and won't take orders. For people like Rush Limbaugh and Coulter who value blind obedience to the power structure this is a threat of the highest order. There is no space for mavericks in their world view, free thinking undermines their values to the core.

It's exactly because of this that voters tend to flock to Obama in the days leading up to their primaries, yet a substantial number break to Clinton at the last second. As inspiring as Obama may be his message of change is scary to the conservative minded. Hillary is the safe path, the choice of the risk adverse, the people who regardless of how they stand on policy are scared of new.

No matter how much conservatives hate Clinton personally, there must be a huge comfort in the pattern, they did Bush then Clinton before, why not keep it going. They wanted Bush as king, but Hillary as queen is far more palatable then a maverick or change agent as president.

Union Experience

Tue, 05 Feb 2008 17:13:08 -0500

Despite being part of "Super Tuesday" New York still hasn't gotten much of the full court political press. Judging from the conversations overhead at the Time Warner repair center today it seems like plenty of New Yorkers just heard the name Barack Obama this morning. Meanwhile the only people I've seen actively campaigning for Clinton are union members outside Grand Central.

It's a pretty remarkable contrast really, gruff teamsters pushing Hillary's tepid literature. It's certainly a sign of progress on one level that the gasp of blue collardom in New York City is out pushing for a female president. But at the same time it's not quite the coalition of the future is it? The hands on down and dirty politics the Clintons love to play certainly fits right into to an old school union hall. But for better or worse it's not really that clear that the hall itself is ready for the 21st century...

Notes on Yahoo Microsoft

Mon, 04 Feb 2008 14:02:37 -0500

Couple quick notes on the Microsoft- Yahoo deal:

- Yahoo and Microsoft are two of perhaps only four companies, the other two being Google and Amazon (via it's Alexa purchase) that have massive databases of information spidered from the web. Given how much effort now goes into gaming these same spiders that historical database just might be extremely valuable. The spidering infrastructure they have is probably even more valuable, except Microsoft already has much of that built via their MSN search already. How much value is there in keeping this out of other's hands?

- Microsoft going into debt for the first time? Signs of a financial empire finally crumbling? There cultural clout of course has been plummeting, but they still have a near monopoly on business desktops so who knows.

- Apple + Yahoo rumors = very interesting.

- The US tech world is always so US centric. Where do the foreign search engines stand in all this? Are there other datamining powerhouses that are below the radar but with a whole lot at stake in Yahoo's fate?

Hype Uncheck

Sat, 26 Jan 2008 18:25:37 -0500

I knew I left something out in my little musical Hype Check, but I couldn't remember what for the life of me. That can't bode to well for the band, but they still got some hype in them... Anyway, the Virgins? The Strokes if the Strokes were actually any good...

What More Can I Say, Top Billing

Sat, 26 Jan 2008 18:21:37 -0500

When Bill Clinton started going after Obama it sure made it easier to see my the right wing hates him so much. But man when he shifts back to attacking the right, it's pretty easy to remember what was so great about him. His praise of John McCainfor instance, is such a deft and subtle political maneuver that it brings a smile to my face. The Clintons clearly have identified McCain as their biggest threat in a general election and by tying him publicly to Hillary, they are striking right where it will hurt him most in his attempt to win the Republican nomination. So nasty but so clever...

"They Thinking Short When They Should be Thinking Long. Shameful Sheeit"

Fri, 25 Jan 2008 20:05:09 -0500

You can't fault Hillary Clinton for not doing everything in her power to win this election, but man you have to wonder when that line between making power grabs and seeming power mad gets crossed. I'm a registered independent and for this election at least I'm voting for whoever the Democrats toss up. And I was quite happy with the three options until a week or two ago. Heck if anything I maybe leans a tiny bit in Hillary's direction. And she's doing everything in her power to make me hate her. Maybe that's what it takes to win the nomination, but is that what it takes to win it all?

No Comment

Fri, 25 Jan 2008 13:01:34 -0500


Off the Waterfront

Wed, 23 Jan 2008 12:28:05 -0500


50 years ago NY was a city of docks. Just about it's entire history and rise stemmed from it's port. It's ability to connect mainland America to Europe, followed by the factories that piggybacked that transport network, the financial firms that swished the money around for everyone, the media companies that circulated the necessary information and the vibrant culture that grew out of that concentration of money, transport and people. Airplanes, container ships and interstate highways finally killed the docks though, and New York's water front slowly decayed and transformed itself into residential communities and parklands.

And for this moment it seems quite nice.

But we are staring straight into the face of an energy crisis. Two questions loom. When does the oil run out? And when do we have enough alternative fuels to not rely on oil? If those two dates overlap, well who cares, the path we are on will stay relatively smooth. But what if they don't.

Maybe, just maybe we'll need those docks back...

Hype Check

Sun, 20 Jan 2008 12:04:45 -0500

Vampire Weekend - The album is not even "out" yet and it's already 6 months too late say that their parents listened to Paul Simon's Graceland too much while they were in utero. They might not steal quite as much from Africa as Paul but they do manage to sound even whiter than he does while in the act. I know they went to Columbia but the African guitars plus indie rock is genius enough that one wonders if they were in the MBA program. Good but not nearly as good as Boubacar Traore. I expect to be guiltily enjoying this while ordering americanos for years to come.

Lil' Wayne - If you say you are the best rapper alive enough times over and over again it just might come true. I'm pretty sure at least half the songs I listened to in 2007 came from a Wayne mixtape. Talk about the album not even being out yet... Fuck "In Rainbows" Wayne is the one blazing the trail for what the future of the music industry looks like. Sure no one quite knows where the money is coming from but you know it works out somehow. Main variable is just how long before Wayne's childstar symptoms take him down the Britney and Michael Jackson path. Plenty of warning signs out there, but so far his growing insanity seems to be more of the musically productive Prince variety...

The Cool Kids - I've been saying it for a while but the music industry really needs to look at the skateboard industry to learn how to monetize a product that's essentially free. The Cool Kids sound like some Columbia MBA realized the same thing and you know it works out somehow. If it comes out in a year or two that some streetwear company cooked them up to sell product I wouldn't be surprised at all. And as long as the beats stay hot I don't really care. As for the rhymes, not bad at all, but they could probably switch up the front men the way skate teams change riders and only the hardcore obsessives would care.