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Must Read #4 for the Week - The Perils of 3x ETFs

|Includes: Direxion Daily Financial Bear 3x Shares ETF (FAZ), XLF

Originally posted on my blog:

On the perils of 3x ETFs, Corey Rosenbloom had a good blog entry on his site afraidtotrade.com yesterday. The article below:
 

I wanted to call your attention to a major fallacy permeating the trading community regarding the 3x leveraged short (inverse) Financial fund FAZ. Let’s compare FAZ and XLF (financial SPDR) and then challenge a common assuption that seems plausible at first, but upon simple inspection, the fallacy comes to light.

FAZ Daily Chart:

The FAZ has fallen 92% from its March 6th high of $115 (as of this writing, it trades now at $8.50 per share). Keep in mind, this almost complete wealth destruction occurred in just over a month. With such a dramatic move possible, it serves as a warning sign for newer traders to avoid these 3x funds… though often newer traders are the ones most drawn to the possibilities (as in, greater than 100% returns in a month which are also possible and have occurred).

Notice the volume surge that has occurred as FAZ plunged to new lows - volume reached over 300 million shares on trading days last week. This is a result of lower prices (which mean we can buy more shares for the same money) and availability to more traders (with smaller accounts).

Be very warned if you’re tempted to think, “I’m going to buy at $8.00 because this fund is going to turn right around and go back to $110 in a month!You are devastatingly wrong - and I’ll show why.

Remember the FAZ is a three-times leveraged fund of the financial sector. Let’s take a look at XLF, the AMEX Sector SPDR to put FAX’s 90% plunge in context.

XLF Daily Chart:

In the same time FAZ fell 90%, XLF rose 92% from its March 6th lows of $5.88 to its April 17th high of $11.33. Is it any wonder a 3x leveraged inverse fund plunged so far? There’s structural mechanics of these funds I don’t intend to discuss here (please read the prospectus and fund description for Direxion), but I want to challenge a common assumption that I heard discussed recently.

Let’s revisit the question “If I buy FAZ at $8.00, and the XLF falls, then FAZ will surge back to $110 if the XLF retests the $6.00 March lows.”

Categorically false.

These fund relationships are not linear but for argument’s sake, let’s assume they are.

XLF falls 50% (let’s make it easy) back to $6.00 per share. This would imply a 150% increase (more than doubling) in the FAZ fund. “Wonderful!” you say, and yes, that is an impressive return. At the $8.00 per share level FAZ is trading now, that would take the fund up to $20.00 per share.

But it is NOT going to take the index back to $110 as some people think.

Assuming linear price logic (which again is not the case due to nuances in the leveraged funds), what would it take to get FAZ back to $110?

For FAZ to move (linearlly) from $8.00 to $110, that would be an 1,375% return.

To get a 1,375% return in FAZ would require a 450% drop in XLF.

Ok, I’m being facetious, but I wanted to challenge the logic that “If I buy FAZ here, then it will shoot right back up to $110 next month and I’ll make a killing.”

The XLF would have to fall bit by bit, step by step, losing 10% in a day here, losing 20% in a day there, losing 5% in a day there on and on to bring the price of FAZ back to the $110 level.

It’s the same principle that if you lose 50% of your account, then you can’t get back to where you started by returning 50% on your reminaing capital - you’ll need a 100% return to get back to where you started. If by chance you lose 90% of your trading account (say, moving from $100,000 to $10,000), then you would need to take your remaining $10,000 and trade it up 1,000% to get back to your original $100,000.

You very well might do it, but you’re not going to do it in a month or even a year.

The same percentage logic goes for those expecting FAZ to get back to $110 any time soon.

Sidenote - the same logic applies to those thinking DXO - double-long crude oil - is going to regain its mid-2008 price highs of $28 any time soon. DXO currently trades around $2.00. Using linear logic (again, only for simplicity), for DXO to move from $2.00 back to $28.00 would be a 1400% move which would imply a 700% rise in Crude Oil.

To drive the point home, if you think DXO is going to get back soon to $28.00, then Crude Oil - which trades at $50.00, is going to have to move up 700% which would take price to $350 per barrel. Do you think that’s going to happen anytime soon?

Don’t fall victim to this “trader’s trap” in these leveraged funds!

Corey Rosenbloom, CMT
Afraid to Trade.com