3x ETFs Are Wealth Destroyers

My recent long position in the Direxion 3X Financial Bull ETF (FAS) was one of my more successful trades of the year.

But it was stupid, and not because of the leverage. I knew it was a leveraged bet. That’s exactly what I wanted. But I also knew that I was going to keep the position for several days, and a 3x ETF is simply the wrong tool for a multiday position.

The 3X ETFs use “total return swaps” to create the leverage. These swaps are settled each day. If the index (in this case, the Russell 1000 Financial Index) goes up consistently, then there’s a good chance that the total return of the ETF will approximate 300% of the return on the index.

But the concept falls apart in choppier markets. In a market that trades up-and-down for a few weeks, and ends up say 10%, a triple-leveraged ETF won’t be up 30%. It might not be up at all.

Consider the results of the FAS and its counterpart, the Direxion 3X Financial Bear ETF (FAZ) over the past six months. Incredibly, both are down over 75%.

Get trend analysis for FAZ from Ino.com

Get trend analysis for FAS from Ino.com

So next time I want to use a little leverage, I’ll use the right tool — either futures or options spreads. From now on, the 3X ETFs are strictly for intraday.

Disclosure: No position

Comments

[jaybny:]

If the index moves the same % for 4 - 5 days in row in the same direction these 3x ETF will be up huge! i wouldn't short them.. its like selling OTM options


On Apr 20 01:11 PM BlackFox wrote:

> Looks like the best thing to do long term is to short these ETFs.
> No way you will end up losing your money.

Apr 21 01:19 PM

[pockyclips ...:]

If you play on the street, ya going to get runned over.

Apr 21 01:40 PM

[Dirk McCoy:]

The combination of the expense load in a middling market and the math of matching swings equaling losses (a 10% up and then a 10% down equals a loss) sure make these look like losing bets to me for the long term- so why not short them?

Apr 21 04:44 PM

[daniel3582:]

I don't have time to sit at my computer all day. I own two businesses, and spend a great deal of time managing those. So, I knew that if I wanted to take advantage of these instruments it would have to be on a swing trade.

So, I've played these instruments only one way successfully. When they've shot through the stratosphere (SKF, FAZ), I've written a dangerous amount of bear call spreads. I.e.,SKF's rocket to $260/share about 6 weeks ago now. Wrote a bunch of them. I didn't care if it went to $300 or $400... I knew when that thing came down, it was coming down hard and fast. I mitigated my risk by selling the spreads for various expiration months.

Which leads me to my 2nd point. When the $DJUSFN loses 5% of it's value in a day, and SKF is at $150, this means SKF should be going to $165. Now, with SKF trading at $60/share, this means the same move will only move SKF to $66/share. The last time the $DJUSFN was at $180-$200 level, SKF was in the $180's. Now it's in the $60's.

SKF will continue to fall in price until it's trading at the same levels that FAS and FAZ are trading at. What will Direxion and ProShares do when their moneymakers are penny stocks? Does anyone have any theories about what they will do to prop up the price? A reverse dividend? I'm curious as to other's opinions.

Apr 21 08:43 PM

[Dustinian:]

I dislike whole sector (especially financial) ETFs in the first place. Unless you know something most people don't, 3x shares seem like a terrible idea to me.

Though there are plenty of gambling addicts in the investment world.

Apr 22 12:29 AM

[pulcheralius:]

This is BS. If you know for sure these are 'wealth destroyers' then you can short them both and make a sure buck, yes? You wanna put your money where your mouth is?

Apr 22 12:36 AM

[Lee Eugene ...:]

The sad part is that so called 'financial planners' or people who want a fee to manage money, but then farm it out to whoever sells there way are starting to get into this game. I had a planner ask me recently about SDS, and she didn't even know that they we buying futures!!!! Does she not read the prospectus?? The answer is yes. After years of trying to get CFP's to buy into these products, we now see them for what they are - bets on the crap table for pro's that want to play. I actually have wholesalers try to come into my office and pitch this garbage as a part of a long term portfolio. Just shoot me now!

Apr 22 08:49 AM

[Eric Peterson:]

On Apr 20 01:11 PM BlackFox wrote:
> Looks like the best thing to do long term is to short these ETFs.
> No way you will end up losing your money.

Shorting an equal dollar amount of FAS and FAZ and holding for several weeks or months is an interesting idea, but that will make money in a choppy market that goes nowhere.

In a strongly trending market you lose big with that strategy. The loss on one position will be much greater than the profit on the other position. The price of one fund can only go down to zero (resulting in a 100% profit on a short position) but the price of the other fund would much more than double, so you lose.

Apr 22 05:10 PM

[allforone:]

Might as well drive to the local casino and put your money on your birthday date. In the end it will all be gone.
Buy with a sell price in mind, either high or low. But that's not much fun is it?

Apr 22 09:07 PM

[rayman:]

So, speaking of wealth destroyers, it's just plain truth that financials are a mess, but let's look at another Direxion example:
Look at EDC (another direxion fun YTD)
It actually hasn't lost it!..........the chart mimicked EEM pretty well
Now if you run the 3 month chart on Yahoo and compare it DIRECTLY to EEM, you will see that EDC is up 60%, EEM is up 20%.
The leveraged ETFs actually lose their value as well based on volatility I would imagine like those silly ultra ETFs (UYG, etc.).
Whilst, us option players face the same risk with theta, but of course, we can hedge our risk as well.
I was short a put spread on FAS at one time, and actually got assigned at 7.5, believe it or not!!! (and sold my 2.5 puts for profit)! Figured it should go up to 10 sometime or another....but nice rebound in March.

Apr 22 09:59 PM

[rayman:]

If you guys think the ETFs are "wealth destroyers", than I have an options strategy:
Just short 2 OTM call spreads on both of them (FAS/FAZ DO have options), of course, just as the article states, the risk is if one or the other becomes directional and is not "flat".
Then you are simply out at zero cost I would think or close to it.

Apr 22 10:08 PM

[rayman:]

nevermind, dis-regard prior post, I think Philip Davis on SeekingAlpha already commented on a not so bad options strategy for FAS!
seekingalpha.com/autho...
How convenient!
(that is if you believe in it)
either way, I guess you can sell naked puts on both FAS/FAZ and end up with one or the other (unless they go to zero! lol)

Apr 22 10:35 PM

[Marc Courtenay:]

This article and this kind of comment are very helpful. For volatile markets like these there are more conservative ways to make profits on both directions. Thanks for helping us all to learn from your experiences.


On Apr 20 01:17 PM Francisco Martin wrote:

> leveraged products are for professionals not amateurs, just as plain
> and simple as that. There is no perfect product to get 3x exposure
> but it is my opinion that these ETFs are great for hedging purposes.
> Hands off if you can't watch the market 24/7.

Apr 23 12:20 AM

[ATWshop:]

2X and 3x are simply "dangerous" and the SEC should limit the investors that can play them... sure we hear about people that make money gambling with them, but very few people are willing to step up and let others know how much they lost due to these crappy products.

I agree with Marc Courtenay... there are lots of conservative ways to make some really nice gains in this volatile market without all the risk associated with these products. Just some old fashioned Due Diligence will provide you with 100s of stocks with just as much up side and very little downside.

As the Author said... Preservation of Capital is just as important as percent of gain.

Apr 23 07:59 AM

[Ryan Vanzo:]

Thanks again Marc, always love your research. If you would like to gain maximum exposure from a specific sector/industry play, what would suggest then if not 3x ETF's? Should the normal investor stay with 1x Funds? I usually like to find beaten down sectors and invest in them for a few years until the become back in factor, but is there anyway to magnify my investments without the compounding problems of 3x ETF's?

Thanks again,
Ryan Vanzo

Apr 23 07:37 PM

[Ryan Vanzo:]

If anybody else would like to answer my questions including the author, I would really appreciate it, thanks.

Apr 23 07:38 PM

[VK Nandela:]

Just buy puts on both FAS and FAZ, you will end up in profit by expiration

Apr 23 11:00 PM

[Microcap Sp...:]

Ryan,

You asked re what tool I would use to gain exposure to a specific sector. That would depend on the sector. For example, if it was the tech sector I would probably use either 1x ETFs or Nasdaq futures but at well under the permitted leverage. If it was something more granular, like homebuilders, I would use either a 1x ETF or if I wanted leverage, an option spread on a 1x ETF or sector leader.

The point of my article was not that sector bets, or even leveraged sector bets, are bad. I only aimed to demonstrate how poor the 3x ETFs are as tools to make extended leveraged bets.

It is true that the companies admit they are not designed for overnight use. They also admit that there will be tracking errors. However, a lot of HNW investment advisors are currently pushing those tools as a means of making a long-term leveraged market bet.

I hope that I have addressed your question. If not feel free to shoot me an email or comment on my blog (I follow those a little more closely and will respond more quickly).

Apr 24 11:10 AM

[GuruJC:]

The article is correct. There's a lot of traders that understand decay. But I'm surprised how many traders don't though. It is a testament to many people right now have taken day trading up as an alternative to heading to the casino (whether they want to admit it or not - that's essentially what they are doing.)

But, what the article fails to point out is that you can make the decay work FOR you rather than against you if you sell short. In fact, I believe these funds offer one of the biggest wealth building opportunities I've ever seen.

Think about this. Equities have taken a HUGE hit the past 2 years and only recently has there been a small bounce. The S&P 500 was at about 1,500 two years ago. It's now at 850 with a potential double bottom possible occurring at about 600 if Swine flu or some other really bad news takes over. So at this point the market is down a whopping 43% from two years ago.

As it has been pointed out, you can actually make money by shorting both the bull and bear 3x funds in a choppy market. But once a trend forms, you'll lose, although you won't lose nearly as much as if you were on the wrong side and holding.

I contend there is a huge reward/risk potential here. We are at or nearing a bottom of a major recession. In the mid term, say 2 to 4 years what is the possibility there will be an upward trend. Extremely high. There may be a pull back before the recovery, there may not, but I would say with 95% certainty, the S&P will be higher two years from now than it is today.

What sector has been hit the hardest during all this? Financials. This sector has the most potential for the biggest mid-term bounce over the next couple of years.

So.... just sell short on FAZ and HOLD it. The decay works in your favor and when an upward trend on the financials forms, hang on for the ride of your life.

But why aren't more investors talking about this strategy? Because 90% of the posts on all the blogs and forums are by Day Traders. These are people who are buying and selling stocks to make a living. The thought of having to HOLD a position is both boring and takes away their available capital for day trading. The long term investor looks at these 3X funds as super high risk. Which they are, if your investment horizon is 6 days to 6 months in my opinion, so they won't touch them with a ten foot pole.

Decay amplifies dips. If a stock is at $10, goes up 50% to $15, then down 50%, it ends up at $7.50 not $10. Eventually these leveraged funds will go down to a point a reverse split needs to occur to bring the price up. If you are short on these, the decay works in your favor. If you are short on the fund that is the bear and the market turns to a bull, you will reap huge profits, the longer you hold onto it the better, up until the point you feel there is a high risk of another recession.

The only thing about this strategy is that you need to be able to stomach a potentially large drawdown before you "break the house" so to speak. If the S&P did do a double dip and go all the way down to 600, or a 30% loss, you wouldn't have lost 90% in a 3X fund, more like 70-80% due to the decay depending on how much you were up in a choppy market. A lot of people can't stomach seeing their invest tank 70-80% in a few weeks. But this is a worse-case scenario. If you hold your short position, you'll still make a ton of money when the bull comes back for real and all along the decay is helping you, not hurting you.

Apr 28 12:02 PM

[Mary LaRue:]

Bottom Line:
3x etfs are money pits if you don't understand their patterns (and yes they do trade in patterns if you monitor their daily movements). I have traded these things in every possible way, and the ONLY way to make money with these is to get in and get out, beating the MM at his own game. And don't EVER buy these when they are in the green. You will lose every single time.

Jun 20 10:36 PM