Tuesday, August 25, 2015

Understand leverage reset decay, 3X ETF decay

a picture is worth a thousand words, and I believe a chart or spreadsheet is much better than words too, check this first:

The first section assume the underline index changes 2% first day and -2% next day and repeat it for 20 days. If you put $100 at beginning, for 1X ETF, you will have $99.60 left, but for 3X ETF, you will have only $96.45, you lost $3, or 3% because of leverage reset decay.

Now let's check the 2nd scenario, for section 2, we assume the underline index changes 0.2% first day and -0.2% next day and repeat for 20 days, for 1X ETF you will have $99.996 left, for 3X ETF it is $99.964, you only lost 0.03% because of leverage reset decay.

What does this mean? This means if the underline index is running in a range and the change everyday is dramatic(high volatility), it is very risky to keep the 3X ETF for a long time. Compare the 2 sections and you find that if everyday's change is 10 times more, the decay is 100 times more. In real world, oil, natural gas and gold prices are changing in a wider range, that is why UGAZ/DGAZ, UWTI/DWTI, UVXY is similar to this, and you can see they loose value quickly. Take a look at the following chart for a better visual impression, if the underline index go up/down 2% every day for 60 trading days, which is about 3 months, the 3XETF lost 10% of value.

Let's move to the 3rd scenario, if the trend for underline index is going up, we can see using 3X ETF gains higher return than 1X ETF. What do all these mean? If you know the trend of an index, It's better to use 3XETF than 1XETF. If not, you better not touch 3XETF, and do not hold 3XETF for long time if the index is NOT moving on a trend!

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