Friday, February 27, 2009

Leveraged ETF Risk

I already computed the decay formula for 2X ETFs in Measuring ETF Decay.

So what about 3X ETFs?

Lemma - Given an underlying A and its daily compounding triple inverse Z, a drop of R-percent in A which retraces fully the following day will DECAY Z by:

12*R2 / (1 - R)

when .25 > R > 0

So decay is TWICE that of double ETFs!

Remember a 10% drop and retrace decayed double ETFs by 6.66%.

Well, a similar 10% drop and retrace will decay a triple ETF by a whopping....

12 * (.102) / (1 - .10) = 13.33%

Theoretically, as we've discussed before, the trade is to *short* these things.

BUT, in practice, that strategy is problematic as shares can become *hard-to-borrow*. For example, I just read a testimonial of a guy shorting DTO - the double oil short - at 120.00 and then getting called away at 170.00.

As far as the financials go, as the tickers slosh around low numbers (i.e. Citigroup, Bank of America, Wells Fargo, and eventually JP Morgan) I think they'll easily be some violent, DECADENT two day price retraces.

So bear in mind, that an *event* like a 20% drop-and-retrace, by the formula above, will knock a whopping 60% off the value of a triple short!!!

Given all that ominous math, yeah, I'm still long FAZ at the moment.

Click here to get started on my stream of trading updates.


JReality said...

If I want leverage, I'll just trade e-mini S&P futures. There is virtually no decay to worry about.

CaptiousNut said...

Yeah, I was trading them in my futures account.

Then I lost most of that capital shorting Treasuries and buying palladium.

I never got around to re-funding that account so I fell into these levered ETFs. I should definitely get back into trading 10-1 margin-ed products that don't decay.

ARAK said...

These days futures are only leveraged 5 to 1 with new margins. Better than 2x and 3x ETFs. if you really want to play 3x and 2x ETFs, using options is a better deal.