DPST - DPST: An Opportunity For Risk-Hungry Investors

2023-04-07 06:48:02 ET

Summary

• I downgraded the Direxion Daily Regional Banks Bull 3X Shares last month, but the recent selloff has led me to revisit the bearish call.
• The economic outlook remains concerning, but the much lower ETF price and a few important developments of late must be taken into account.
• I stay away from DPST while resetting my rating from sell to hold.

Recently, I posted an article on the Direxion Daily Regional Banks Bull 3X Shares ( DPST ), downgrading the leveraged ETF to a sell. The share price quickly tumbled by nearly 50% through April 5, leading one reader to ask a follow-up question: "Has your position changed since you wrote this article?"

Below I explain how it has. In fact, partly because the ETF price moved so sharply in favor of my "sell" call, I now return DPST to my "hold" column and explain what the rating means in this context.

DPST: A quick recap

Those that are new to this ETF might benefit from a quick recap and some important warnings before even thinking of getting any closer to this high-octane trading vehicle. The Direxion Daily Regional Banks Bull 3X Shares is a triple-leveraged fund that tracks the S&P Regional Banks Select Industry Index. A quick shortcut way of thinking about it: DPST should produce three times the daily returns of the SPDR S&P Regional Banking ETF ( KRE ).

Those that follow the markets, even if only tangentially, know that regional banks have taken center stage in the past month or two. With the collapse of Silicon Valley Bank and its ramifications, DPST has lost three-fourths of its value in the past 10 weeks alone. See the purple line below.

Below is how I have previously summarized what I believe to be the most important disclaimer about DPST:

Leveraged instruments have particular risks that other investment vehicles do not. Most notably, volatility drag (also known as volatility tax, beta slippage, value erosion, decay, and other names) makes a long-term investment in LETFs more exposed to losses than many realize.

This is the case because these funds reset daily, as per their stated methodology, making it nearly impossible for the long-term performance of the ETF to be equal to three times that of the underlying asset - returns can be worse in the case of high volatility in the market. FINRA and the SEC elaborate further on these risks, and I suggest readers go through their warnings thoroughly before committing any capital.

Why DPST is no longer a sell

In my bearish argument, I defended that 2023 was not like 2020 - when, in March of that year , I saw an opportunity to place a small bet on DSPT eventually rebounding from the depths of the pandemic.

Today, interest rates are substantially higher than they were then. The Federal Reserve is committed to slowing economic activity as much as possible to contain inflation, whereas the Central Bank's focus three years ago was clearly to ensure that the economy survived the initial impact of COVID-19. Regional banks, of course, are highly sensitive to interest rates and the shape of the yield curve.

None of the above has changed since last month. I still believe, as I argued only a few weeks ago, that "a recession has not been this obviously telegraphed in many decades." Cyclical sectors like financial services can still take a hit from what's very likely to come, and it is anyone's guess whether stocks fully reflect the potential headwinds.

That said, there is no doubt that the nearly 50% drop in DPST since my previous article was written makes the YOLO ("you only live once") trade more compelling. The further DPST dips, the better the chances of a vicious rebound eventually taking shape.

Also, even if the economic outlook has not changed much recently, a few important things have happened. First, the Federal Reserve and the US Treasury have offered compelling evidence that they will not allow the financial system to collapse, which is good news for regional banks. More specifically, the federal government guaranteed deposits made with SVB, while the Fed provided liquidity to the sector through the Bank Term Funding Program.

Second, in a turn of events supported in part by the challenges faced by the financial institutions, the case for interest rate cuts as early as this summer (less likely in July, more likely in September) has started to emerge . This, in my view, would be bullish for bank stocks and their derivatives, including DPST.

Make no mistake: DPST is speculative

Having said the above, I do not see DPST as an obvious buy for a simple reason: the risks remain enormous.

For starters, regional bank stocks may continue to tank before finding a bottom, a process that can take months or even years. But also, even if bank stocks move sideways for more than a few weeks, DPST can still suffer greatly due to high volatility producing beta slippage and eroding the price. The table below shows what could happen to DPST if KRE stays flat but produces 50% in annualized volatility: a loss of 53% in a single year.

This is why I have suggested that potential traders and investors that choose to go long assume that the price will go to zero or very close to it and be positively surprised if or when it doesn't. For such a move to make sense, one would need to size the bet on DPST accordingly - that is, very small within a portfolio that holds otherwise relatively safe assets.

One plan of action is the "bulkhead approach" that I talked about in 2020. Rather than betting on regional banks through an ETF like KRE, one can pair two-thirds cash with one-third DPST and create a limited downside, unlimited upside trade, since cash would theoretically hold 100% of its value. As mentioned above, however, brace for the possibility that the DPST piece could head to nearly zero, and only commit "disposable capital".

Another strategy is to go long call options on DPST, an approach that costs quite a bit in the form of option premium, but that also allows for large gain opportunity coupled with a hard floor on the loss side. Below are the contracts currently available for September 2023, according to Yahoo Finance .

Personally, I would favor old-school trend following. For instance, holding DPST only above its 200-day moving average and selling shares below it would nearly ensure that the trader is only riding the trend higher, not lower. Losses can still occur, but they would likely be small.

The main downside of this strategy is that it requires daily monitoring of the position, which is probably consistent with the very idea of owning a triple-leveraged ETF. Also, following the trend means that a trader would probably miss the first jump of 20% or 30% in DPST's recovery. But the ETF returning to its 52-week highs (if it ever does), for example, implies an upside potential of more than 400%. Missing out on the first knee-jerk reaction in exchange for downside protection is a very good deal, in my opinion.

Conclusion: What the hold rating means

To sum it up, I can see the case for owning DPST in an attempt to ride a recovery that, if it happens, could be gigantic. But due to the equally gigantic risks, I would only consider going long DPST if the trade had enough downside protection built into it.

For now, I stay away from DPST, while resetting my rating from sell to hold.

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