I love the smell of volatility in the morning.
While that may be true of intraday scalpers or even contrarian traders, it's not the siren's call of all traders, especially those dipping their toes in the leveraged ETF game. This is a segment of the market I covered well before most. In fact, the introduction of leveraged ETFs and the controversy around them was the entire reason I began writing for Real Money. It's been more than a decade since I begin explaining the proper uses, misuses, risks, rewards, misunderstandings, and possible strategies around ETFs. I've even managed to convert a few folks here to join in the explanation of the risks.
The biggest challenge is we're often using theoretical numbers to really drive home the point. It often went something like this:
Day 1 - the index climbs X%
Day 2 - the index falls (1.5)X%
Day 3 - the index rises Y%
Day 4 - the index falls (1.5)Y%
Then, we compare what kind of market move you need to get back to breakeven. It's a valid and practical exercise, but it can easily be brushed aside. People review it and think markets don't move with that kind of oscillation or symmetry. We've been spoiled with trends the past decade. And leveraged ETFs love trends. They reward them handsomely when you are correct on the trend, and actually punish you less when you're wrong.
But volatility... well, that's a different story.
This year has been chalked full of volatility, so I thought it might be an opportune time to check out the impacts of what I call "Volatility Decay" on leveraged ETFs. This is the impact of the ETFs needing to reset their leverage to the market each night after the close, so it can be accurate for the next day's move/change. Unfortunately, this results in a repeated process of buying higher highs and selling lower lows. That's not a recipe for long-term success.
Let's take a vision look over the past 7, 30, and 90 days at the SPDR and it's 3x leveraged counterparts on both the bullish and bearish side. I should note, these ETFs are not broken. They act very closely upon what they are intended to do. What's generally broken is the understanding of the product. They are DAILY products, not weekly, monthly, or quarterly.
Over the past week measured in trading days and not including today, the (SPY) (S&P 500) fell 2.9%. Three times that number is 8.7%, but you can see the impact the daily resets have on performance as the 3x long (ProSh UltPro S&P 500) fell 10.85% while the 3x short (PS UltPro Sh S&P 500) rose only 4.46%.
Over the past 30 days, the SPY has fallen 8.82%. During that same period, the 3x long has fallen 27.28% while the 3x short rose by 24.19%.
Over the past 90 days, the SPY has risen 0.78% while both the 3x long and 3x short S&P 500 ETFs have FALLEN by 3.46% and 7.51%, respectively.
This isn't limited to the S&P 500. Take a look at the gold miners as shown by the VanEck Vectors Gold Miner ETF (GDX) compared to the Direxion Daily Gold Miners Index Bull 3x Daily (NUGT) and Direxion Daily Gold Miners Index Bear 3x Daily (DUST) .
Over the past 7 trading days, GDX is virtually unchanged at -0.17% while NUGT has fallen 5.33% and DUST has fallen 5.58%. So, a trader in GDX has lost virtually no money while BOTH the NUGT and DUST owners would be down more than 5%, and that's in only 7 trading days.
If we extend to 30 trading days, we find GDX is up 4.05% while NUGT has risen 4.32%. That means a trader could have earned basically the same return long GDX for 3x less risk than NUGT. During that same time, DUST fell 19.52%, almost 5x times as much.
It doesn't get any better at 90 days. GDX up 8.26%, NUGT up 11.07%, and DUST lower by 33.86%. I will say this one isn't quite as bad, and if you extend to 200 days you would begin to see how trend plays into not harming being wrong as much, but you're still way behind on the upside capture being in the leveraged ETF play.
These real-life examples don't mean leveraged ETFs are without their use. They can make terrific short-term and intraday trading vehicles. There are some arbitration strategies that can be utilized for those with patience as long as the positions don't grow too large or trends ignore, but, for the most part, if you aren't flipping these quickly, don't get involved. They are for the active trader virtually glued to their screens. And since I don't see the volatility ending soon, make certain you understand how daily reset impacts performance even if you are a pro. Sometimes the little things can sneak up on you.
Take care out there today!