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Volatility Decay of Leveraged ETFs - A Third Study

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February 05, 2010 – Comments (3)

The post will be another looking into Volatility Decay and a response to some of the questions on my other blog. Please see these two posts for reference:

anchak - 2/3/4.../n X Leveraged Strategy : Weapons of Wealth Destruction or Creation - Attempt at DIY Primer - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=132045

binve - Volatility Decay of Leveraged ETFs - Another Study

binve - Volatility Schmalatility

So if you believe that Ulta ETFs are ALWAYS going to kill your return if you hold them more than few weeks....

That is not what I said. From this post:

This is why I have said again and again that leveraged ETFs are trading vehicles only! You should never view them as investments. Over the long term, Volatility Decay will DESTROY your returns!.

I personally hold them for only a few weeks at time, because I view these as trading vehicles only. And I do short term swing trading for only a few weeks at a time. But what I said above is over the long term these instruments will destroy your return. This, it seems is the source of contention because "long term" to one investor or trader will not be the same definition to another.

When I use the term "long term", I am typically referring to the timeframe of my investments (which is why I distinguish between short term swing trades, longer term swing trades (not investments!), and investments). The language is confusing, and I apologize. But my intent is clear, again from this post:

I have several investment accounts each with a different purpose / risk tolerance / timeframe:

-- Short Swing trade: Leveraged ETFs, Highly speculative momentum plays - Days / Several Weeks
-- Long Swing Trade: Unleveraged ETFs and outright longs or shorts - Weeks / Months
-- Investing Account: Gold / Silver / GSMs / Commodities - Years

Lets look at a long term (3 years in this case) chart of SKF and UYG so that we can really see Volatility Decay in action:

ENLARGE

We can see the change in slope of the trendline for the pair going from low volatility to high and then back to low. A very visible phenomenon at work.

And for those who invested in either SKF or UYG (again, using the more traditional definition of investing which usually has the connotation of years) there is a loss component of your total return that is absolutely independent of the stock move. That loss term is always there. It changes slope during high volatility or low volatility, but it always points down.

And like I discussed in my recent post: Volatility Schmalatility, and I think volatility will be increasing substantially in 2010. Which means the decay slope will get worse in 2010 (IMO).

how then holding TNA, FAS, etc. from March 2009 until January 19, 2010 - almost 11 MONTHS was the best "investment" anyone can do comparing to 90% of stocks out there?

Again, the word investment is subjective especially when quoted like this. Refer to what I wrote above.

Regarding the gains from March 2009 to January 2010:

This is a very fair point. From March to Jan, we had a period of decreasing volatility and a spectacular bull run. Going long on Long Ultra ETFs was a very winning strategy. I take exception to the term "investment" here, but I am not debating the returns.

Those people who are smarter than me knew / guessed that the bull run would last a long time and that volatility would decrease, and that made for excellent gains with these instruments.

But if the next phase of the stock market is going to be characterize by increased volatility (which I believe it is), even if we just get a very volatile trading range and not a crash, will ultra ETFs do just as well relatively speaking as they did the last 10 months?

The answer I come up with is: No. And I point to the orange section on my chart above as evidence.

Whether you agree with me or not is immaterial. I am offering up my opinion for your to review and / or discard as you feel appropriate. I have a reason for my opinion which I am sharing above and in the last few posts. It is up to you whether you find it valuable / actionable or not. I am not trying to convince anybody of anything. That is not, nor has it ever been the point of my posts. I have an opinion, and sometimes I state my opinions in a very loud manner :) But ultimately the point of my post is to state my opinion and you can decide how to use it.

3 Comments – Post Your Own

#1) On February 05, 2010 at 11:35 AM, portefeuille (99.56) wrote:

which is the underlying it is supposed to track

during one trading session with a leverage factor of -2.

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#2) On February 05, 2010 at 12:11 PM, portefeuille (99.56) wrote:

#1 (p1(t)-p1(t0))/p1(t0) ≈ l * (p2(t)-p2(t0))/p2(t0),

where p1(t) is the price of the leveraged ETF at time t, p2(t) is the price of the benchmark at time t, t is in the period starting at the close of trading day n (=:t0) and ending at the close of trading day n+1 and t0 and l is the "leverage factor". 

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#3) On February 05, 2010 at 12:26 PM, portefeuille (99.56) wrote:

n+1 and t0 and

n+1 and

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