The bid-ask spread is going to be the hard part here. It is possible to be correct about the inefficiency of leveraged ETFs but to also not have an opportunity to profit because maybe the B/A is 20 cents on each leg.
Did you check bid-ask spreads before you posted this?
Right now TQQQ has bid/ask of 21.35 / 21.36, and SQQQ 45.44 / 45.45.
UPRO 36.49 / 36.50 and SPXS 20.43 / 20.44
TMF 9.60 / 9.61 TMV 110.35 / 110.44
That last one was the only non $0.01 bid-ask spread I found, and it represents 0.08% of the bid price, which is a very narrow spread. I don't understand your claim that "the bid-ask spread is going to be the hard part here".
I think ChpBstrd is referring to the b/a on options. Thus, why trading one "expensive" underlying and one "expensive" is problematic (e.g. lots of 100 make the LCD a huge number of shares).
You can either pay borrow fees, or pay a wide b/a spread if you go 'synthetic short'.
Vand nailed it. There is a convexity issue that works against the strategy.
Oh, I 100% agree with wide bid-ask spreads on options. The longer until expiration, and the further from the current price, the worse it gets.
But I've already gotten better at bearish investing based on this idea. Each underlying index has two leveraged ETFs, one bullish and one bearish. And leveraged ETFs have volatility decay, which hurts performance long term. Surprisingly, Schwab charges almost nothing to short these ETFs.
I believe inflation will surprise the market in the next few months - possibly next week. Instead of buying SPXS as a long position (-3x S&P 500), I have shorted UPRO! So the usual 3x S&P 500 becomes -3x S&P 500 as a short position. But now I have two ways to win: if the market drops, or if volatility decay kicks in. Shorting the 3x ETF benefits from either (do not try this at home). Unfortunately it gives up a huge benefit of leveraged ETFs: limited losses. If you invest $1,000 in SPXS, that is the most you can lose. If I short UPRO for $1,000 my short position can cost me $-2,000 if UPRO doubles. Stop loss orders become a very good idea, plus watching the investment more closely.
But at this point you're talking about a leveraged directional trade rather than an arbitrage trade. I.e. there is a way to lose big if the market goes against your thesis, as opposed to an arbitrage trade where two counter-correlated assets mostly offset each other and a small return is earned at small risk regardless of market outcome.
My thought on shorting UPRO rather than going long SPXS is that there's probably a cyclical swing like with contango and backwardization, where sometimes the drag is worse on UPRO and sometimes it's worse on SPXS. However I don't have the technical knowledge to form this hypothesis into a full theory. If nothing else, maybe there's a premium/discount to NAV that swings around between these funds.
I would be interested to know if shorting UPRO was more profitable for the same market down move than going long SPXS. It would be easy to put together a backtest which might reveal any issues across multiple calendar dates. I'd also be curious if someone could make a profit at "short $X of UPRO / long $3X of SPY" arbitrage that could beat today's 1 year treasury rates.
I'm not sure how to fix flaws in the original idea, but I wanted to mention how I benefitted from it. Yes, I'm making directional trades against the market.
I interpret your mention of "contango and backwardization" as meaning you should read about 3x ETFs. Besides reading and learning about volatility drag, I've also looked at raw market data and convinced myself it explains the performance problems.
Using Yahoo Finance data, I looked at the opening price of SPY, UPRO and SPXS for the past 11 weekdays. Dividing each day's price by the prior day gives price performance. Consistent with those ETFs objective of +300% and -300% exposure to the S&P 500, their median leverage was -303% and +307% in the past 10 days.
Over those 10 days, SPY performance was -1.71%. Triple that is -5.13%, yet UPRO returned -5.94% while SPXS returned 4.78%. My favorite way to see volatility drag measures SPY at two times where it had almost no change, like 11/28 to 12/6 when it rose just +0.08%. Yet UPRO was -0.42% and SPXS -0.90%. This is volatility drag in action.
Extreme example, SPY -20% then +25% :
SPY 5 x -20% -> 4 x +25% = 5.0
UPRO : 5 x -60% -> 2 x +75% = 3.5
SPXS : 5 x +60% -> 8 x -75% = 2.0
During the above extreme example, holding SPXS results in a -60% drop. Shorting UPRO results in a +30% gain (owing 3.5 on a 5.0 loan). As I mentioned above, shorting risks unlimited losses, which can mean needing stop loss orders and careful monitoring.
You mentioned an idea, $300 SPY and short $100 of UPRO, which should have no net market exposure. In the extreme example (15.0 SPY -> 15.0, UPRO -5.0 -> -3.5) you wind up with $40 profit from volatility drag, less the cost of shorting.
Using the past 10 days of data with this market neutral idea:
$300 SPY x -1.71% = $294.87 (loss 5.13)
shorting $100 UPRO x -5.94% = -$94.06 (gain 5.94)
Which equals a gain of $0.81 on the combined long + short position.