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Wednesday, April 29, 2009

Double and Triple Leveraged ETF's Investor's Beware!

Today I'll tell you why investor's should never be confused with trading instruments. With the popularity of ETF's came these funds which use 200% and 300% leverage. These are extremely dangerous, and nobody should hold onto any leveraged ETF for the "long run", they are almost sure to lose you money! These instruments are ideal for traders not investors! Let's start by identifying what a leveraged ETF does. A double leveraged ETF uses 200% (triple uses 300%) leverage to capture a specific basket, sector, or index move. Let's take the very popular SDS which is a 2X inverse tracking the S&P 500, for every 1% move up in the S&P 500 index SDS will move down by 2%, and for every 1% move down in the index SDS will move up by 2%. Similarly is the SSO which is the 2X tracking the S&P 500, for every 1% move up in the S&P 500 index SSO will move up by 2%, and for every 1% move down in the index SSO will move down by 2%.

If you're the person who says: It's a great way to hedge my portfolio, so what's the problem with them? Then clear all your other thoughts and read this post carefully- it may save you some $!

It is basic math that so many people overlook! Let's use the benchmark S&P 500 index for an example. Let's say we start off on the S&P 500 at 1000 and a double and triple leveraged ETF both at $100 per. If the benchmark index moves down 10% in 1 week to 900, and assuming both ETF's track perfectly it would put the double leveraged ETF at $80 per share, and the triple leveraged ETF at $70 per share. Here is where investor's don't think and assume that when the S&P gets back to 1000, the leveraged ETF will trade at the identical value as before, when the S&P was at 1000... THIS IS FALSE! Basic math tells us this is not possible. In order for the benchmark to get back to 1000 it will need to go up by 11.11% which will correlate to a 22.22% and 33.33% move in the double and triple ETF's respectively. As we can see in order to get the double ETF back to 100 from 80, the benchmark will need to increase by 12.5% correlating to a 25% increase in the double ETF. The triple leveraged ETF will be even tougher to get back to 100. In order for the triple ETF to get back to 100 from 70, the benchmark will need to increase by 14.283% correlating to a 42.85% increase in the triple ETF.

To show how this works I have created an Excel spreadsheet. I have downloaded historical data on the S&P 500 Index for exactly one year, back to the closing index value on April 29,2008. Assuming these leveraged ETF's track perfectly with the change in the index (which is incorrect but they do track very closely), the spreadsheet shows the changes for 4 different leveraged ETF's. The ETF's tracked are: Double Leveraged Long index, Triple Leveraged Long index, Double Leveraged Short index, and Triple Leveraged Short index. I also started each ETF at 100 on April 29, 2008 (this is not where they started, but will not make a difference in the % change). These ETF's don't assume any capital gains distributions, splits etc...


As you can see, for the past year the index is down 38.52% but the double and triple leveraged Short ETF's are up 44.35%, and 26.61% respectively. Many would have assumed the double and triple leveraged short ETF's would be up 77.04% and 115.56 respectively over this period... This is certainly not the case. Also at the bottom of this spreadsheet I have created a simulation to show how the index (over the next 250 days) could get back to even (back to the index close on April 29, 2008) and the resulting % changes from $100 per share for each leveraged ETF. This proves how dangerous they are... They are all down even when the index is back to even!

It certainly depends on the price these ETF's are purchased, but over the long run, based on simple mathematics, they are sure to deteriorate. This is why these are great instruments to trade, not invest... Investor's beware!

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Anonymous said...

This comment could be completely worthless since I am unsure if you are able to short an ETF. However, this blog leads me to believe that shorting equal positions in two opposing ETFs (ie: FAS & FAZ) would undoubtedly make money over the long run. Could it really be this easy?

Anonymous said...

Thanks for the article. It's essential for investors to be well informed of the characteristics and risks. I am traiding the FAS and FAZ as the volatility does provide relatively predictable patterns.

I too am not sure you can short them, nor would I want to, but there are PUT options available for both.

Anonymous said...

Wow! Very informative and wish I read this before trying a QLD/QID option writing strategy. Must admit I can't believe when I was working through the math on this I overlooked such a basic fundamental element of 2x and 3x leverage.

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