The 3X Index ETFs from Direxion have been all the rage since they launched and picked up traction on the heels of the Proshares 2X Index ETFs of yesteryear, going Long or Short various indices as outlined below. For the uninitiated, you can now get triple the return of say, an energy ETF or emerging markets ETF in a given day (note: I bolded “day”). These Triple Return ETFs have been both a blessing and a curse for retail investors, depending on whether they timed their bet right (referring to a leveraged inverse sector ETF as an “investment” is a stretch) on both a directional basis and on a velocity basis. Why, you might ask, would it matter when you bought into a particular ETF Short as long as the underlying index eventually moved downward during your investment horizon? That’s the rub. As many articles as I see on the virtues of these turbo charged instruments, I see twice the number of comments and questions on message boards from investors asking how the heck a triple short ETF can lose money when the underlying sector index declined over a given time period. The answer is Daily Balancing. Take a look at the real-life example below.
3X ETF Short Loses Money in a Down Market!
As a proxy, consider the XLF Financials ETF. Now, the applicable 3X sector ETFs are FAS (3X long) and FAZ (3X inverse). We all know what happened to Financials last year, but in recent months, Financials have actually rallied somewhat, since the Depression era scenario that our politicians painted for us in order to justify massive bailouts did not occur. During 2009 YTD period (almost 6 months as of the time of this writing), XLF is down only 6%. Now, if you bought FAZ with the intent of tripling the inverse return of the Financial sector loss of 6%, you’d think you’re looking at ~18% return over the same period right? Well, OK, there’s an expense ratio, so you’d be happy with say, 16%, right? Well, take a look at this chart of how FAS and FAZ performed vs. XLF and tell me if you’d be upset looking for a payday of 16% on FAZ:
Summary:
1X Underlying Index ETF -(-6% Return)
3X Long ETF -(-64% Return)
3X Short ETF – (-84% Return)
They All Lost Money! How Could This Be?
This is because of daily rebalancing. It’s virtually a mathematical certainty that if you don’t catch a massive, sustained trend on the underlying index, due to the daily volatility component, you’re going to lose money over long periods by holding the 3X ETF Short or Long, no matter what the underlying index is doing.
Here’s another alarming example. Going back to the Financials, since the 3X ETFs didn’t exist throughout all of 2008, but the 2X Proshares did, which employ a similar approach, with XLF losing 60% from Jan2008 to present (May2009), you’d think you could have made a killing on the 2X ETF Short Financials SKF, right? Wrong! You actually lost 55% in the 2X Inverse ETF XLF at the same time the underlying index was hammered. And of course, if you were 2X Long with UYG, you lost 91%. All 3 lost money again.
Huh?
With Triple Long and Triple Short equivalents for the underlying Emerging Markets ETFs, Energy ETFs, Financials ETFs, etc. all have wild volatility, you could end up losing your shirt if you bet the wrong way. And if you want to give yourself an extra jolt with options, they’re quite expensive as well due to the implied volatility (yes, the Triple ETFs do offer derivatives as well. It’s like strapping a nuclear warhead to a conventional incendiary bomb). I’ve modeled some of this myself and in conjunction with looking at historical charts, over long periods, it seems to be a net loser game unless you cherry pick discreet perfect time periods to have bought and sold.
Short ETF Pairs Trading Strategy
Since leveraged ETFs tend to decline in value over time due to daily rebalancing, I’ve shared the results of my dual-pair inverse Short ETF Strategy. The results are astounding. In any market, I’ve both backtested and personally achieved double digit gains with no direct correlation to the underlying index.
All 3X Leveraged ETF Short and Long Options from Direxion
Below is a listing of all the 3X ETFs currently offered by Direxion (visit this comprehensive list of all leveraged ETFs including the 2x sector funds from Proshares):
Triple Long ETFs Index Tracked Index Ticker
| BGU | Daily Large Cap Bull 3x Shares | Russell 1000 | 300% | RIY |
| MWJ | Daily Mid Cap Bull 3x Shares | Russell Midcap Index | 300% | RMC |
| TNA | Daily Small Cap Bull 3x Shares | Russell 2000 | 300% | RTY |
| ERX | Daily Energy Bull 3x Shares | Russell 1000 Energy | 300% | RGUSEL |
| FAS | Daily Financial Bull 3x Shares | Russell 1000 Financial Services | 300% | RGUSFL |
| TYH | Daily Technology Bull 3X Shares | Russell 1000 Technology Index | 300% | RGUSTL |
| DZK | Daily Developed Markets Bull 3X Shares | MSCI EAFE Index | 300% | MXEA |
| EDC | Daily Emerging Markets Bull 3X Shares | MSCI Emerging Markets Index | 300% | MXEF |
| TYD | Daily 10-Year Treasury Bull 3x Shares | NYSE Arca Current 10-Year U.S. Treasury Index | 300% | AXTEN |
| TMF | Daily 30-Year Treasury Bull 3x Shares | NYSE Arca Current 30-Year U.S. Treasury Index | 300% | AXTHR |
Short
|
||||
| BGZ | Daily Large Cap Bear 3x Shares | Russell 1000 | -300% | RIY |
| MWN | Daily Mid Cap Bear 3x Shares | Russell Midcap Index | -300% | RMC |
| TZA | Daily Small Cap Bear 3x Shares | Russell 2000 | -300% | RTY |
| ERY | Daily Energy Bear 3x Shares | Russell 1000 Energy | -300% | RGUSEL |
| FAZ | Daily Financial Bear 3x Shares | Russell 1000 Financial Services | -300% | RGUSFL |
| TYP | Daily Technology Bear 3X Shares | Russell 1000 Technology Index | -300% | RGUSTL |
| DPK | Daily Developed Markets Bear 3X Shares | MSCI EAFE Index | -300% | MXEA |
| EDZ | Daily Emerging Markets Bear 3x Shares | MSCI Emerging Markets Index | -300% | MXEF |
| TYO | Daily 10-Year Treasury Bear 3x Shares | NYSE Arca Current 10-Year U.S. Treasury Index | -300% | AXTEN |
| TMV | Daily 30-Year Treasury Bear 3x Shares | NYSE Arca Current 30-Year U.S. Treasury Index | -300% | AXTHR |
Disclosure: I am utilizing a Short Treasuries Strategy with the 2X short Proshares ETF TBT since the 3X wasn’t out at the time…and shorting Treasury Bonds has been the easiest money I made all year…but due to daily rebalancing, I should take my double digit gain now and run!
Disclosure: Various leveraged ETF strategies are in play, both short and long.
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At one point, I actually shorted both the FAZ and FAS because of the time decay factor that you explained. I held for a few months and sold both positions at a profit.
I’ve tried recently to do the same, but have had troubles finding the shares to short one or both of these instruments.
The track record is amazing on these things with regards to losing money while holding them for any length of time. They should really only be used as a trading vehicle with a very short time horizon.
.-= Kevin´s last blog ..Women and Money: Is Spending Your Fix? =-.
Kevin,
Thanks for your note. We think alike!!! I’ve investigated this at length and currently have a few “experiments” going on with some strategies I’ll be posting about eventually (want to build some more data and real-trade info to share).
Here’s the problem with shorting both. While initially, sounds awesome, the way these daily resets work, if the trend is strong in one direction or the other, you’ll actually have a net loss since one position moves more than the other. For instance, let’s say FAS ran 100% during a Financials upswing. Obviously FAZ can’t lose 100%, it may lost say, 75%. So, you will have a net loss of 25% (or perhaps 12.5% depends how you classify) with equal starting positions.
Take a look at the 3 month back chart today (9/18/09). FAS is up 85% and FAZ is down 60% since the momentum has been so strong in the upward direction for Financials. So, in this case, you’d be down.
On having shares to short, I did have some trouble with one of my attempts and even got a note from Ameritrade that they may have to liquidate a short position due to lack of shares (after I already had a position/strategy), but it didn’t happen. So, in huge quantities, I would assume it’s difficult to get the shares. Perhaps you’d have to spread around a few brokerages, but then you’re looking at more commissions.
Stay tuned for update on how I actually made this work (I’m getting there!).
SCOPELABS Reply:
September 16th, 2011 at 12:42 am
@Darwin, WELL FROM maY U COINED $ SHORT BOTH faS AND z NO? LOL
what do you think of using them as a vehicle to generate income, mainly by selling waaaay out of the money puts (approx. 40% below current market price)??
For example selling Jul 12 puts on FAZ (collect approx $1) and also selling Jul 40 puts on FAS (collect $3.25)
I just stumbled upon your blog yesterday and have been reading your posts. I’d like to get your opinion on this crazy idea…
It’s an interesting thought. The reason I’d advise against it is that by selling puts on regular stocks, at least there’s the chance it returns to the strike price and you’re basically just “buying shares at a discount” while collecting premium. However, since over the long term, these don’t tend to rise in value, especially after declining 40%, if they do in fact reach that trigger point, it’s unlikely you’d ever see anything more than continued losses as the instrument declined further over time (while you’re holding the shares once exercises).
I’ve struggled with finding multiple ways that would work but haven’t found the holy grail just yet that sufficiently balances risks with returns. To date, I’ve only used them for a brief trade here and there when I see a trend that’s too good to pass up.
Is it “stupid” interesting thought or “hhmmm” interesting thought?
secondly, if FAS precipitously goes down even if XLF keeps moderately trending up or stays flat, then how about selling at ATM calls expiring in 6 months out? The premiums are quite hefty (about 20%) and FAS will still be closer to your buying price (certainly not 20% down…
No, not stupid at all. I considered that one as well. The problem is, if you take a look at some trends that have taken off (say, FAS from March onward), not only did FAS run, but it completely took off. The 20% or so premium you may snag will be dwarfed by the 100%+ run on the upside swing.
So, if you sold the calls uncovered, there are unlimited losses up if the trend takes off (this could even occur if you sold calls on both FAS and FAZ at the same time). If you sold covered calls, you will get the 20% premium and cap your upside, but may very well lose more than 20% on the downside.
Without knowing the trend, it’s tough to capitalize on the daily volatility loss (the curse of the market trader).
Another thing to note is that volatility has died down considerably from last year, so the degredation I referred to will not be quite as rapid unless volatility picks up again. Unless we have a “crash #2), it’s unlikely to see Financials that volatile again in our lifetime.
when I said selling calls on FAS, I meant covered calls. I agree that the volatility has come down substantially, making selling puts less profitable. But FAS/FAZ still are in mid 80’s to mid 90’s, making them attractive candidates for this trade.
Thanks a lot for your input. and thanks also for very informative posts on your blog.
Sorry guys I am confused about all the chatter about 3x etf FAS losing money. Take a look at this chart over at google. http://www.google.com/finance?q=xlf%2Cuyg%2Cfas
Any display other than the 1 yr because of the reverse split shows as I would expect. uyg 2x % and fas 3x % above the baseline. I just don’t see this loss you talk about when holding these ETFs.
The charts in the post are right from Google Finance; depends on the time frame you’re looking at. It’s not cut and dry, but in summary, take any underlying sector, like say XLF for the Financials. Then plot FAS and FAZ or whatever 2x/3x long/short against it. Over long periods of time, the long will not be anywhere near 3X the underlying, and may even lose money even if the 1X was flat or gained. Meanwhile, the short is completely underwater like 70-90% loss. There is a single exception – (which applies to financials during the bounce) – if there is a prolonged, upward trend, the 3X can roughly return 3X or perhaps even a little more. But, as soon as volatility kicks in, it erodes the position completely.
Take a few different examples, plot them over long periods like 9-15 months and you’ll see. Virtually every time it’s a loser on both ends.
Darwin,
My point was that the graph link I posted shows me 1x, 2x, 3x return when compared to XLF just as expected. Look at any graph on either side, to make it easier to see, of the reverse split for FAS and you see an outperformance of the XLF. I bought FAS at $4 last spring and still hold it and holding the XLF for that same period does not provide the return that FAS has todate. I agree on the short side that FAZ fails I would not hold FAZ for more than a day or so for the trend. I don’t agree on the case of FAS on the Long side since they actually own stock and pay dividends in the case of FAS and UYG. Maybe I am to simple minded but when I see a chart over the time I have owned FAS showing 3x vs XLF 1x percents returns and see it in my account I conclude they work as advertised.
Hi Lee,
Your timing was impeccable. Last spring (March 9 to be precise) was the exact pivot bottom of the worst economic collapse our generation has seen. This is basically the ONLY type of situation where grabbing a leveraged ETF and holding for an extended period would work.
To demonstrate, check out the same exact link, but shift it back a few months. Look at even a very brief period like say, Jan 2-Apr 3 2009. Just a few months right? XLF only lost 17%. UYG lost 43% and FAS lost 66%!
To demonstrate further, I’ve identified a flat period for XLF – Jan 2 – May 21 2009. XLF is exactly flat during this period.
You’d think a 2x and 3x might be roughly flat right? Or perhaps down just a bit due to fees/tracking error. Well, UYG is down 29% and FAS is down 58%.
After studying/modeling these at length, they’re pretty bad over long periods unless you hit that perfect storm, as it appears you did. I just wouldn’t expect the party to continue.
Lee,
To help you get your confusion over how could you lose money in FAS, I strongly recommend you to read thru’ a simple example on pg. 3 of the prospectus for FAS
here’s the link:
http://www.direxionshares.com/pdfs/DRX_prospectus.pdf
hope it helps.
Darwin> You’d think a 2x and 3x might be roughly flat right? Or perhaps down just a bit due to fees/tracking error. Well, UYG is down 29% and FAS is down 58%.
Lee> I would expect this since it move 3x that would be absolutely correct it move up 3x/2x and down 3x/2x.
Yes I know about the daily reset. But it seems to me that is exactly what we want on the Long side FAS and UYG. Match the current days performance each day and over time, not just one small snap shot, it follows the trend up or down. The short side is just indexs and long side is index and stock and it seems to me that the fact FAS and UYG own stock makes it works out. The daily reset gets the true price of the stock on any given day. Thanks for the discussion.
> Jan 2-Apr 3 2009. Just a few months right? XLF only lost 17%. UYG lost 43% and FAS lost 66%!
If reference the wrong line in the previous post. use this one.
Would now be a good time to buy EDC ? I reckon it is !
I decided to cash in on leveraged ETF business too, its like printing money. So I am making my own super 4x leveraged ETF 🙂 I can do this cause I am very good at options trading and make all kinds of spreads to do what ever I want. The new symbol is HOSE. I will give you my short layman’s version prospectus to save us all time and clear up any confusion caused by lawyer talk. My new fund HOSE will be more volatility than Sponge Bob on crack. And like crackheads in general it will run all over the place and wind up going nowhere. Now when you want to sell your shares of HOSE like everybody else does its price will drop faster than Las Vegas home prices. HOSE will have a propensity to make big gaps down just before you thought it was time to sell. Now that you have the basics down to my new leveraged ETF gimme your money caused somebodies getting hosed and it an’t me ;0)
Tom – I guess you should have bought some EDC on the 9th instead of channeling your bitterness into rambling sarcasm.
Great post. Leveraged ETFs may go up and down and lose money over the long run, but do you know who always makes money on ETFs in every market ?
The companies who offer them!, A little management fee every day, come rain or shine.
I follow the basic tenet of this post, but nothing is quite as certain as it appears, in life. As noted previously, the key issue is one of reversion from the mean and of compounding of either positive or negative returns, to produce most of the times yields that are lower than the corresponding index yield.
One point about the FAZ vs. XLF plot during the period March 2009 onwards. First, the index corresponding to FAZ is the Russell 1000 Financial Services (RGS) Index ($RIFIN.X). Comparing FAZ to XLF is not strictly correct.
The sharp decay during the April and May month corresponds to a sharp drop in volatility – as rightly said – determined by a change in accounting rules (i.e., mark to market vs. mark to fantasy) – a historical, one of a kind event.
Conversely, to a rise in volatility should correspond a higher risk that the underlying index would decrease, with higher expected prices for FAZ. It all depends on the magnitude and intensity of the change in volatility and of the corresponding market drop.
I firmly believe that, should a rise in volatility reoccur, with herding behavior on the selling side of the index, instruments like the FAZ would have a sudden, certainly temporary but however extremely significant upward jolt in price.
The compounding works in two ways – it erodes returns when volatility drops, but it enhances returns when volatility increases – making the current market price relative to volatility attractive.
Nobody can rightfully predict the upward movement should such an event occur, since it is more an issue of mass psychology and herding than anything else. I would however expect that FAZ would move in an exponential fashion (caused by the herding phenomenon) to upwards of several hundreds USD – albeit for the relatively short amount of time of the fear outbreak.
دردشة
Hi Darwin,
Thanks for your info.
May I ask what the risk is for options, if you know the longer trend is up, say, for gold.
For example, you lock yourself in with a call option for UGL and just buy and hold.
I am struggling to understand this “daily rebalancing” – is my understanding of this, for example , in 2 months the NASDAQ falls 5% on aggregate. But of course the falls are not linear, like what we saw on Friday, it went up. So, all these ups (if you’re shorting), may add up to be GREATER than the fall of 5% because ETFs are based on DAILY percentage losses and gains.
So the risk of options is that they would just expire worthless?
I shorted FAZ and FAS a year ago today and have made 30% on both. I plan to hold them indefinitely unless the brokerage forces me to close them. A month ago, I took the profit from FAS and FAZ and shorted TNA and TZA. One of those has so far lost 7% while the other has gained 25%.
For most of the year, the FAS and FAZ short was losing money but eventually it turned around.
Yes, this strategy can lose money if the market runs but nothing runs forever. Eventually the market has to change direction which will destroy the ETF that is performing well.
thanks for the’s
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