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Leveraged ETFs - Why they are not good long term holds

post #1 of 17
Thread Starter 
These are meant to be daytraded or short term swing traded, not held for any considerable amount of time. This video does an excellent job of explaining the process of how these leveraged vehicles operate and why they are not meant to be held long.

post #2 of 17
It's good to short them after drastic market moves.
post #3 of 17
Good video
post #4 of 17
xxx
post #5 of 17
Nice vids. Unfortunate they didnt mention crude oil tracking leveraged etfs. The contract rollovers add a whole additional element to return destruction thanks to the nasty contango WTI is suffering from (worse then brent). I saw an article that said USO held up to 20% of outstanding crude futures contracts for the front month trading at some points. Wonder if that has any truth to it. Mentioned that when USO had to rollever to the next month it actually distorted the market quite significantly for the 3 days it was transitioning.
post #6 of 17
Thread Starter 
Quote:
Originally Posted by kingtime View Post
Nice vids. Unfortunate they didnt mention crude oil tracking leveraged etfs. The contract rollovers add a whole additional element to return destruction thanks to the nasty contango WTI is suffering from (worse then brent). I saw an article that said USO held up to 20% of outstanding crude futures contracts for the front month trading at some points. Wonder if that has any truth to it. Mentioned that when USO had to rollever to the next month it actually distorted the market quite significantly for the 3 days it was transitioning.
Yep, but eventually the opposite of contango, backwardization, will start to take place, where the front month is more expensive than the further out contracts. So when you rollover, you get an instant boost instead of the loss you take from contango.
post #7 of 17
Quote:
Originally Posted by simonyadig View Post
Yep, but eventually the opposite of contango, backwardization, will start to take place, where the front month is more expensive than the further out contracts. So when you rollover, you get an instant boost instead of the loss you take from contango.
Looking foward to that

I'm sure years from now they will be blaming "ETF Speculators" for the high price of oil
post #8 of 17
This deserves a bump.
post #9 of 17
explain to me this

Why does it matter the daily fluctuations, since you are buying shares ? What does it matter what it does daily, as long as you sell higher than you bought?
post #10 of 17
Thread Starter 
Quote:
Originally Posted by cuzzin_elias View Post
explain to me this

Why does it matter the daily fluctuations, since you are buying shares ? What does it matter what it does daily, as long as you sell higher than you bought?
Did you watch the video? Obviously as long as you sell it higher than you bought it at, you'll be fine. The point is, these are not meant to be held for long periods of time. As long as the price moved in your direction, you're fine. As soon as it starts to trade sideways or back and forth, the more the price decays. There is a reason why both of these are trading so far off of their highs.
post #11 of 17
Quote:
Originally Posted by simonyadig View Post
Did you watch the video? Obviously as long as you sell it higher than you bought it at, you'll be fine. The point is, these are not meant to be held for long periods of time. As long as the price moved in your direction, you're fine. As soon as it starts to trade sideways or back and forth, the more the price decays. There is a reason why both of these are trading so far off of their highs.
But how is this different than regular stocks in this sense? What does it mean to reset daily?
post #12 of 17
Great video. More people need to know this, for sure -- I didn't do the math when I started trading leveraged ETFs and so I wasn't aware of the decay effect. Admittedly, I have broken this rule as I have been holding URE for 3+ months but fortunately for me it has paid off during that time period.
post #13 of 17
For anyone who's interested, especially if you don't yet understand why leveraged ETFs decay, the following explanation may be informative (I hope). I was suddenly inspired to write a quick pseudorandom simulation program and I copied the results over into Excel to make some visual aids. For starters, let's imagine we have an index that's at $100 and two ETFs both priced at $100 as well. One ETF tracks double the daily return of the index, and the other tracks double the inverse of the daily return. It's a common scenario we're all familiar with, so here's what we can expect to happen if the index is trending upwards.



Obviously, I'm assuming that the ETFs track the index perfectly, which isn't always quite the case in reality. Anyway, notice what effects compounding has had on the percentage return of the ETFs. Our index returned 13.94% over 4 weeks, while the bullish ETF returned 29.19%. Notice that this return is greater than 27.88%, the double of 13.94%. Meanwhile, the bearish ETF lost 24.14%, which is less than 27.88%. When the index trends up, anyone invested in the bullish ETF makes more than double the return of the index, while anyone invested in the bearish ETF loses less than double the return of the index. This is due to daily compounding. Now on to the second example, which is just the opposite.



Note here that the index has lost 12.70%, again over a 4-week period. However, the bullish ETF has lost 24.87%, less than double the loss of the index, and the bearish ETF has gained 26.00%, greater than double the loss of the index. What these two examples tell you is that the daily compounding of leveraged ETFs actually works in your favor, no matter which ETF you're invested in, so long as there is a definite positive or negative trend in the index being tracked. However, look at what happens when the index stays at approximately the same level.



As you can see, the index traded up and down a bit over the 4 weeks, but closed at the same price at which it opened the period. However, both ETFs are showing a loss. This is what we're talking about when we mention decay, and it's caused by daily compounding of the leveraged percentages. The above example shows the index as fairly stable, so check out what happens when it's more volatile.



In this last example, the index is considerably more volatile than before, trading more than 5% in either direction regularly. As a result, the decay of the ETFs is greatly magnified in comparison to the previous example. Which ETF experiences greater decay depends on the intermediate moves of the index. The lesson to be learned here is that volatility magnifies decay in leveraged ETFs, which is why the video in the OP chose 10% moves to make its point.

Of course, this doesn't mean you have to flip leveraged ETFs quickly or face the results of decay. They're okay to hold for as long as there is a definite trend in your favor, which could be several weeks or more. But many people are fooled into thinking that they're solid long-term investments -- after all, some leveraged ETFs even pay dividends -- and that's simply not true. An index that doesn't go anywhere -- or one that experiences a quick reversal -- can drain leveraged ETFs that track it, and volatility will only increase losses. Bottom line: know what you're getting into when you trade leveraged ETFs, and know when to get out.
post #14 of 17
Thread Starter 
Wow, can't believe I missed this post. Thanks for the charts, very awesome.

Quote:
Originally Posted by Rishodi View Post
For anyone who's interested, especially if you don't yet understand why leveraged ETFs decay, the following explanation may be informative (I hope). I was suddenly inspired to write a quick pseudorandom simulation program and I copied the results over into Excel to make some visual aids. For starters, let's imagine we have an index that's at $100 and two ETFs both priced at $100 as well. One ETF tracks double the daily return of the index, and the other tracks double the inverse of the daily return. It's a common scenario we're all familiar with, so here's what we can expect to happen if the index is trending upwards.



Obviously, I'm assuming that the ETFs track the index perfectly, which isn't always quite the case in reality. Anyway, notice what effects compounding has had on the percentage return of the ETFs. Our index returned 13.94% over 4 weeks, while the bullish ETF returned 29.19%. Notice that this return is greater than 27.88%, the double of 13.94%. Meanwhile, the bearish ETF lost 24.14%, which is less than 27.88%. When the index trends up, anyone invested in the bullish ETF makes more than double the return of the index, while anyone invested in the bearish ETF loses less than double the return of the index. This is due to daily compounding. Now on to the second example, which is just the opposite.



Note here that the index has lost 12.70%, again over a 4-week period. However, the bullish ETF has lost 24.87%, less than double the loss of the index, and the bearish ETF has gained 26.00%, greater than double the loss of the index. What these two examples tell you is that the daily compounding of leveraged ETFs actually works in your favor, no matter which ETF you're invested in, so long as there is a definite positive or negative trend in the index being tracked. However, look at what happens when the index stays at approximately the same level.



As you can see, the index traded up and down a bit over the 4 weeks, but closed at the same price at which it opened the period. However, both ETFs are showing a loss. This is what we're talking about when we mention decay, and it's caused by daily compounding of the leveraged percentages. The above example shows the index as fairly stable, so check out what happens when it's more volatile.



In this last example, the index is considerably more volatile than before, trading more than 5% in either direction regularly. As a result, the decay of the ETFs is greatly magnified in comparison to the previous example. Which ETF experiences greater decay depends on the intermediate moves of the index. The lesson to be learned here is that volatility magnifies decay in leveraged ETFs, which is why the video in the OP chose 10% moves to make its point.

Of course, this doesn't mean you have to flip leveraged ETFs quickly or face the results of decay. They're okay to hold for as long as there is a definite trend in your favor, which could be several weeks or more. But many people are fooled into thinking that they're solid long-term investments -- after all, some leveraged ETFs even pay dividends -- and that's simply not true. An index that doesn't go anywhere -- or one that experiences a quick reversal -- can drain leveraged ETFs that track it, and volatility will only increase losses. Bottom line: know what you're getting into when you trade leveraged ETFs, and know when to get out.
post #15 of 17
I was looking for this thread the other day, making note of it again.
post #16 of 17
I've known for quite some time that these leveraged ETF's are not meant to be held as long term investments, but I didn't fully understand why. This video does a great job of getting the point across.
post #17 of 17
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