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Leveraged ETFs - Be Careful!

Options Trading

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In terms of leverage, three kinds of ETFs are

available

single: it tracks the movement of securities of a sector or index, "one by one"

double (ultra): produces 2x change in case of 1x movement of the linked underlying product

triple: produces 3x change in case of 1x movement of the linked underlying product.

In order to present the potential dangers of leveraged products, I have chosen the single XLF financial sector ETF. This ETF tracks the performance of the financial sector as a single product.

Let's see what ultra and triple ETFs follow the movement of it:

Ultrashort: SKF - a 1% drop of the underlying product (XLF) results in 2% increase of SKF

Ultra Long: UYG - a 1% increase of the underlying product (XLF), results in 2% increase of UYG

Bear 3x: FAZ - a 1% drop of the underlying product (XLF) results in 3% increase of FAZ

Bull3x: FAS - a 1% increase of the underlying product (XLF), result in a 3% increase of FAS,

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Three versions of a simulated market

environment

The following table shows three versions of a simulated market environment:

-> Low volatility-> Moderate volatility-> High volatility

The simulation shows trading over 10 consecutive days and the % of change that was reached by the end of the 10th day for the different leveraged versions.

To get started, let me ask you a question:

Would you assume that, during a very volatile 10-day period, a 10% drop of the XLF was accompanied by the drop of Bear3x FAZ and not by the rise of it? Note: it fell and did not rise, although it should have risen 30%, according to the "rule."  Shock! I talked to a lot of people who did not understand why they lost money on leveraged ETFs when they should have made a profit.

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Now you can find out from the table!

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Let's analyze the table for a while

-> Low volatility: the XLF rose 5% in case of low volatility and, accordingly, the leveraged ETFs changed by almost 10% and 15%, matching the 2x or 3x leverage.

-> Medium Volatility: after a slightly more volatile 10-day trading, the XLF rose 2.75%. With the leveraged ETFs, however, you can see the difference. In principle, the change of the 2x and 3x leverage ETFs should have been 5.5% and 8.25%. Here you can see that there are differences. While UYG stayed below the 2x level, SKF performed above it. The same refers to FAS and FAZ as well. FAZ performed well above 8.25%.

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Let's look at the most shocking case

-> High volatility: in the same time period, but with crazy volatility, (which is not uncommon these days) XLF dropped 10.99% in 10 days. According to this, the 2x should have moved 21.98%, the 3x 32.97%. Unfortunately, the reality is not so simple. UYG is close to the expected level with its 26.9% decrease, but with SKF, we see a pretty interesting number. XLF dropped, while the short ETF rose 2.6%.How is that then? In principle, according to the rule, the SKF should have risen, as in case of 1% drop of XLF, it should rise 2%. In contrast, it increased only by 2.6%.

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The situation is even more extreme with 3x

leverage

The situation is even more extreme with 3x leverage.

FAS dropped 45.64%, although it should have "only" dropped 32.97%. In contrast, the short version, FAZ dropped 5.81%, although it should have increased 32.97% !!!

Attention: FAZ, which is the short ETF of XLF, has not increased, it has dropped, in case of a drop of XLF on a high volatile market.

Mathematically, this can be explained very simply, however, it is difficult to work up psychologically :)

It is worth it to spend some time examining the table above before you jump into a leveraged ETF purchase.

The lesson:-> % change of a leveraged ETF can vary significantly in different volatility environments. Be careful!

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Feel free to ask me!

Email: gery@optionsrules.comMy webpage: http://www.optionsrules.com/

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