As have many others, I observed awhile back that leveraged ETFs have a tendency to decay when markets sway back and forth. Perhaps nowhere is this more evident than the triple leveraged financial ETFs, FAS and FAZ. FAS goes up 3x the daily move in the russell 1000 financial index and FAZ does the inverse. The interesting thing is that both securities have managed to lose about 90% or so of their value since their inception less than a year back. It is notable that one or the other has occasionally tripled in a short period along the way. However the gains always proved fleeting as a change in direction in the market of even a moderate magnitude is usually enough to wipe out any gains. I won't get into the mathematical principle here but suffice it say that over time, these instruments are destined to decay (unless the underlying market goes the same direction every day for eternity) and because they reset daily, the decay is somewhat permanent in nature. While some traders use these tools to leverage short term moves in the market, I think there's a better way to take advantage of these instruments.
The easiest solution is to short both securites at the same time and simply wait for them to decay over time. In my experience, however, this is not feasible because it's hard to borrow the securities (nobody really owns them for very long). The practical solution is to short call options on both securities with as long a time to expiry as possible to allow more time for decay (I prefer way out of the money to keep margin requirement low and provide more room for error). In the short run, one side of the trade could explode in the wrong direction but it's extremely likely to reverse and further erode itself with the next change in market direction. It's worth noting that the premiums received for this strategy are very generous as well. I have no current position in these ETFs but I have successfully executed this trade in the past. It's high risk short term, but highly predictable in the long run (and not that long a run at that). It also has a very high return on capital as it takes very little capital to margin the position initially. Doing both sides reduces the volatility and improves the risk reward of the trade. The best part is you can win on both sides of the trade! Just to demonstrate how far out of line the pricing on these options can get, I earlier this spring sold a 25 strike call for Jan 2011 on the FAZ for 4.50 when the FAZ itself was only at 8.80! The option lost about 80% of it's value within a couple months and decayed so much that it became unlikely the ETF would ever again reach the strike price of 25. It did however reach that price recently but only by reverse stock split. This seems like a great trade for a hedge fund to use alongside it's other strategies as it is likely to earn a positive return in any environment given a little bit of time.
Disclosure: No position.