oftwominds-Charles Hugh Smith

More on Trend Changes and Leveraged ETFs 

April 20, 2009 

A number of savvy readers wrote to warn me that leveraged ETFs like FAZ are extremely risky due to the manner in which they degrade in periods of high daily volatility. Today we look at DOG, a 1X (unleveraged) Short Dow ETF as another lower-risk way to increase one's wealth in a market decline.

It turns out my "Long Bomb from the end zone" football metaphor was more valid than even I expected. A number of knowledgeable readers kindly wrote to explain that 3X leveraged funds like FAZ (mentioned yesterday: Is the Financial Tide About to Ebb? (April 18, 2009) are extremely risky due to the way sudden sharp increases in the underlying index/basket of stocks can drive them to zero.

Put another way: a long "Hail Mary" pass is inherently risky. It may result in a game-winning touchdown or a game-losing interception. Tossing long bombs every play is not a strategy for winning football games; it must be chosen only at times when risk is drastically reduced--like when the opposing cornerback trips and falls, leaving your wide reciever wide open.

Let's turn to readers' astute warnings:

S.

If the Russell financial index that is the basis of FAZ goes up 33.3% then would your investment goes to a price of a penny and if it then cratered 33.3 percent the next day you would have shares priced at .03? Very risky investment; be careful.

Matt S.

As a long time investor, I'm telling you the most important thing about these 2x and 3x ETF's is that basic math proves they will ALL eventually go to ZERO.

Watch :

Start : You buy FAZ @ 100
Day 1 : Financials go up 10 % - FAZ goes to 70
Day 2 : Market goes down 10 % = FAZ goes to 91 (1.30 * 70)
You have lost 10 percent yet the market has essentially gone nowhere.

Now just repeat those days again and again and FAZ goes to Zero EVEN THOUGH THE MARKET IS STILL IN THE SAME PLACE.

Or how about this:

Start : You buy FAZ @ 100
Day 1 : Financials go up 33 % - FAZ goes to 1

Your IRA is wiped out.

And finally, the odds of FAZ even hitting $40 again are infinitesimal. Basic math again - the biggest move up FAZ has EVER made is about 250% - that means, in the best case scenario, FAZ could go from $9 here to a max of $23 - IF you could even get lucky enough to make the same move.

Bill L.

I noticed you said you've moved a significant portion of your IRA to these instruments, and I'm sure you've done your research on these, but my first statement is be careful.

The basic sense is that these stocks degrade over time, regardless of the direction of the market, particularly over the longer period. Even after a share rises considerably, it still has a tendency to come crashing back down (The higher the price, the harder the fall).

My biggest point with these things is that they have a tendency to degrade over time (look at FAS and FAZ, both under 10 now, starting at around 40), and compound under either short term strong trends, or long term low volatility moves (think a longer term bull). However, high volatility can kill them, without the market going anywhere.

As an exercise, imagine that the stock market moved up 5% for three straight days, down 5 for three days, up for 5, and down for five one more time. In this case, the underlying stock would have moved -1.5%, while the triple levered bull ETF would have lost 12.8% (an 8x multiple, not 3x). Under high volatility these stocks degrade, even if the market does not really choose a direction. If you are right, congrats, but if you are wrong, or even if your timing is wrong, this could have a horrific impact on your IRA.

Personally, I've started to purchase about 30-40% OTM (out of the money) quasi straddles (puts on a 3x pair) and played it that way, because in this market, the first guarantee is large daily percentage moves, and large moves that you really don't expect. In those cases, the reward on these positions is great.

Bill L., http://www.evilspeculator.com.

Thank you, Bill, Matt and S. for the explanations and kind warnings. So as I understand it, extreme daily volatility acts like Kryptonite on these 3X and 2X ETFs, degrading their value in a one-way direction. That leads to the conclusion that they're best deployed as very short-term trading mechanisms in "Throwing Long" situations where you have high confidence in the trend (i.e. you just saw the cornerback slip, leaving your wide receiver open).

This degradation can be seen in the chart of the SRS, a Real Estate Bear 3X fund:

Having been duly warned of the high risks inherent to leveraged ETFs, I want to remind readers once again this is all the freely offered musings of an avowed amateur observer; please read the HUGE GIANT BIG FAT DISCLAIMER to clarify that this is NOT INVESTMENT ADVICE. If you want investment advice, locate a qualified professional and pay them for their services (after checking their track record and professional standing, of course. Caveat Emptor in all things.)

Now let's take a look at the 1X (that is, no leverage added) DOG ProShares Short Dow 30 for any evidence that the six-week uptrend is about to reverse into a downtrend:

To recall a key bit of the previous entry:

The single most powerful investment concept is that going against the trend destroys your wealth and riding with the trend increases your wealth.

So the question is: what evidence is there in the chart of DOG that the market uptrend (which because the DOG is an inverse/short/Bear ETF, appears as a huge decline) has lots of room to run?

Precious little, in my view, as MACD and Stochastic are both suggesting a change of trend is at hand. Those who follow volume have noted a decline in overall volume traded (a bad thing for a Bull uptrend) and those who follow investor sentiment have noted a substantial rise in investor euphoria/positive sentiment.

Contrarians believe those Bullish indicators mark market tops.

If things are looking up, why are company insiders rushing to sell, sell, sell their shares? That too usually marks tops, not bottoms.

Conclusion: those who believe a trend change is at hand have multiple ways to profit from the turn downward. These include options (puts), selling short, and the short ETFs (1x-unleveraged, and 2X and 3X-leveraged). Winning the game requires a long-haul strategy. In investing/speculating, the first key to a successful "game-winning" strategy is to get the trend right.

The second key is to be willing and able to modify your strategy if you get the trend wrong.

DISCLOSURE: As of the market close on Friday, April 17, I also own puts (options) on BAC (Bank of America) and KBH (KB Homes). 


Thank you to everyone who emailed me recently. My computer time has been very limited due to the intrusions of "real life" and so I remain behind in all digital work. Thank you for your patience and understanding. 

Thank you, Jeff S. ($10), for your much-appreciated generous contribution to this site. I am greatly honored by your support and readership.