What Every Trader Must Understand Before They Trade Leveraged ETFs Like NUGT & DUST

Sep. 14, 2013 7:53 PM ETDUST, NUGT, GDX, GLD31 Comments
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Contributor Since 2012

Contrarian daytrading technician who specializes in locating high probability short term trades while predicting price movement directions with over 85% accuracy. Most of my trading involves either extremely short term micro scalping of stocks or commodities (using 1 minute bar charts), or swing trading of stocks overnight. I also specialize in weekly stock option premium selling, along with pre-market and post-market psuedo market maker and stealth trading activity, and selling commodity option strangles (selling delta neutral pairs of far out-ot-the-money puts and calls), with the intent to achieve a steady 1% weekly return. After 32 years, well battle tested, very opportunitistic while putting capital preservation as tantamount. Rehabilitation Counselor over 20 years, M.S., M.B.A., now an around-the-clock speculator. Incorporate seasonals, time of day, and other patterns and methods where high probability price movement patterns can be statistically forecast. Know how to safely go long high beta, heavily shorted stocks; know how and when to use extremes in sentiment to take the other side. I like to fade extreme moves as my proprietary methods are based on reversion to the mean theory. Developed my own scale trading and money management techniques. Will change and adapt my trading style based on current market conditions. I hope to start a chatroom devoted to teaching speculators how to see and capture daytrading opportunities. They say that those who can...do, while those who can't....teach. I want to provide teaching from someone who really can do, someone who knows how to make steady returns while experiencing minimal drawdowns. As a mentor, I would love to share my knowledge and support to help small traders. I came from humble beginnings and have never forgotten it. I want to accelerate the learning curve of my chatroom students so they won't have to make all the mistakes that I have over the years. I am excellent at devising and implementing strategies that can quickly turn a losing trade into a net winner.

In this article I am going to cover some basic knowledge that every trader must know before they trade any leveraged ETF, but especially the triple leveraged ETFs like DUST & NUGT. If you learn only one thing from this article, it is that the 3X ETFs are trading vehicles meant for day traders and Not For Long Term Investing. Suppose you believe the gold mining ETF: GDX is going to rally but instead it falls 33%. If you buy the triple ETF: NUGT instead, and hold it through the fall, it will go down (33% X 3) or 99%, virtually wiping you out in a loss you cannot recover from. Had you only traded a Double, (2X Leverage) ETF it would take a 50% drop to wipe you out. The more leveraged the vehicle you trade, the more precise your timing must be. Since 12/13/10 when the triple ETFS of DUST and NUGT began trading, GDX has fallen from the low to mid 60s to the low to mid 20s. Going to 60 to 40 is a 33% drop, and from 40 to 28 is another 33% etc. More than two wipeouts at the bottom. Scary indeed!

Triple ETFS Have Horrendous Slippage!

Consider this example. Suppose one was trading a stock priced at $100, and it falls 10% and then goes back up 10%. What would the price be? Not $100 again, but only $99. Falling 10% brought a price of $90 and then taking 10% of $90 you only add back $9 so you end up with a price of $99. Once anyone suffers a 10% loss, it will take a 11.1% gain to get their money back.

Now suppose one was trading a double leveraged, (2X) ETF. Starting at $100, a 10% loss is doubled to $20 instead of $10 leaving a price of $80. Then taking (10% X 2) 20% of $80, you would gain back $16 and end up with a price of $96. To get the $80 price back to $100, it requires a gain of 12.5% in the base security to achieve the 25% gain in the 2X ETF from $80 to $100! Just a bit more than the 11.1% unleveraged. There is $4 of slippage with the Double ETF compared to the unleveraged stock that only had $1. To calculate slippage, a quick formula is to take the amount of leverage and square it. With (2X) ETFs you take 2 and square it (2X2) and you get $4 of slippage. Using this same formula, to calculate the slippage of a triple ETF you take the square of 3 (3X3) and you get $9 of slippage. To see if this is correct, lets do it the long way. $100 priced Triple ETF losing 3X10% or 30% would drop to $70. Then taking 30% gain on $70 one would add $21 which leaves $91. Sure enough, $9 of slippage. If you are in a triple ETF at the $70 price, to get back $30 to reach the $100 original price, requires a gain of 42.9%, and an up move of 14.3% in the underlying entity. 14.3% is significantly more than 11.1%.

This illustration is only for a 10% loss and then a 10% recovery. Suppose we were talking about a large loss like 25%. As the loss percentage increases, the challenges of getting back even in a triple leveraged ETF are magnified! Without leverage, a drop from $100 to $75 (drop of 25%) would then require a move back up of 33% to get your money back. In a triple ETF though, losing 25% is multiplied by 3 to a loss of 75%, leaving only $25. Now to get back to $100, the triple ETF must rally $75 (300%) or a move back of 100% in the underlying security. How often do you get a rally of 100% after a fall of 25%?!

Divide Your Money Up In Tranches & Average Down

Thus when trading triple ETFs one must never buy all in at one price, and if wanting to get long 100 shares, it is always better to buy 50 at one price, leaving money for 50 more should we dip lower, to average down. I allot $20,000 to $25,000 for day trading DUST, less with NUGT. With DUST around $35, I can buy 100 shares as many as 6 times as we dip.

Take Partial Profits And Set Up Win/Win Scenarios!

Suppose we have a hard dip and I am fully invested at 600 shares, a somewhat rare occurrence on a single dip. As soon as I can break even on the bottom 300 shares, I take profits on those, and hold the top half of my position for more gains. This way I have taken partial profits and set up a win/win scenario. If we rally up more I have shares to take off at a profit. But if we dip again, I have funds freed up to buy more and average down lower. I try to never hang more than 200 shares when I am a 600 share day trader. If the market rallies a bit more but I can't quite get out at a profit on the high shares, I sell half of my remaining shares (150) at a loss and add the loss to the purchase price of the remaining 150 shares. Then as we dip down, I buy back 150 shares at the lowest price I can, leaving me 300 shares total and don't touch my remaining cash. I will usually never get any larger than these 300 shares until the 150 "hung" shares are free. If the day ends and I can sell the low 150 shares at a profit, I get those off, leaving only 150 "hung" shares to work out the next day. The next day I can use my free cash to buy 450 shares to quickly free up those final 150 shares and start over. By trading this aggressively, I almost always have my money back on losses with the stock never coming anywhere close to my original purchase price.

Good Rule To Follow: If Holding A Losing Position At The End Of The Day, Sell Out Half Of The Position At A Loss

For someone who cannot trade as aggressively as I do, a good rule to follow is to cut any losing positions in half at the end of the trading day. This again creates a win/win. If we open lower the next day, you can buy back the shares sold at a loss at a lower price, thus averaging down. If we open higher, you have added the loss to the original purchase price of the remaining shares and on sufficient strength, you will have your money back, or your loss will at least decrease, because we are rallying. Either way, you are better off. There is no downside to selling out 50% of your position on any losing trade, the very second, and I mean the very second you realize you are wrong! If the market is falling fast and you are long, it might pay to completely liquidate and then buy back at the bottom when it stops falling. If you get out quickly enough with a very small loss, it won't have to rally much out of the bottom to get your money back.

Triple Leveraged ETFs Lose 10% Of Their Value Each Month

I could not get the chart to print, but if you go to Yahoo Finance you can punch up a chart of NUGT and then select the "Compare" tab and add "DUST" so that two charts are on top of each other. I just did a 3 month chart of this which clearly shows DUST has lost 20% of its value in the last 3 months, and NUGT has fallen 40%. That is an average loss of 30% over the three months, or 10% per month. There are 22 trading days in a month, so there is slippage of 0.455% daily, or 2.25% weekly. If day trading, one would never notice the slippage, and a week's worth of slippage at 2.25% is tolerable. But holding month after month, at 10% per month, is catastrophic.

You Just Can't Short Both ETFs For Guaranteed 10% Monthly Returns

The obvious question would be, "Why don't I go short NUGT with half my money, (in a margin account of course) and go short the other half in DUST". It would seem you would net a guaranteed average return of 10% per month or 120% per year, not counting compounding. If you got that same chart working that I described above, but changed the time frame to "1 year" you will see that a year ago, NUGT had a pre-split (2 reverse split) price of $900.50 a year ago, while DUST was trading at $11.85. While all your money was quickly lost in NUGT, in late June 2013, DUST had a 600% gain at the peak. Suppose you had $100,000 invested with $50,000 short NUGT and $50,000 short DUST. At the worst spot, you would have earned $50,000 in NUGT very quickly, doubling your money on that $50,000. But you would be down $300,000 on the DUST side for a net loss of $250,000. So anyone shorting these vehicles remember to not do them long term and get out quick when losses begin to mount.

What Is The Optimum Time To Hold A Position In These Vehicles?

If swing trading, one should never be holding a position longer than 1 to 2 weeks and at no time can I imagine ever holding a position beyond a month. What is optimum? Well, day trading in and out for seconds, minutes or an hour or two at a time is optimal. You will notice from my StockTalk running commentary that I usually completely go flat at some time about every day, so I can reassess if I want to hold anything till the close. The best time to add any position size is in the aftermarket as the thin trading allows for 50 cent to $1 discount prices that virtually assure instant profits when the ETF trades unchanged the following day. After the day is completed, studying can be done to see if GDX should open up or down the next day. If there is an 85% chance GDX will open up, then buy NUGT for a good morning pop in the premarket. If odds favor a down opening in GDX, then buy shares in DUST (especially if you can buy them at a discount) and then dump them in the premarket the next day. I trade through Interactive Brokers and I can trade in the premarket beginning at 4:00 a.m. New York time (5 1/2 hours before the markets open) and trade in the aftermarket until 8 p.m. (4 hours after the close). I make some money outside regular trading hours playing the bid/ask spread, but most of my money comes from correctly predicting an up or down opening the following day. In the last couple weeks I made $200 or more on my worst days trading during regular hours, and $500 or a bit more on my good days trading during regular hours. My daily goal is to make $200 per day trading DUST or NUGT, or $1,000 per week, during regular trading hours. However, my over night trades purchased at a discount in the aftermarket and sold out in the next day's premarket strength, netted me thousands.

Don't Try And Get Cute Catching Turns

You are rarely ever going to catch the turn perfectly and you really don't want to try. The reason is that it can happen so fast, you can miss it and "hang shares" and quickly suffer great losses. When my target of $35 to $37 was hit on the top end, I was gone! I was only going to lightly scalp after that as the risk/reward odds do not favor staying in after initial targets are met. Catch the "meat" of the trade, the middle. While picking a bottom, trade small. Trade big once bottom has established itself, and play small or not at all as one reaches for the top. Start the day small with 50 or 100 share trades, move to 200 shares after profits are booked. Go back to 50 to 100 as the day wears on, or move on. Better to make the easy money. Don't tie up your capital in a losing trade. It drains your resources; your mind, your heart, your nerves, and your purse.

Although I have been quite fortunate in predicting recent price moves in DUST with uncanny accuracy, such predictions are not necessary to be a successful trader. What I really care about is knowing the current trend so I have the correct trading bias of bullish or bearish. This can change day to day and sometimes hour to hour.

If You Aren't A Day Trader, Trade GDX

Since you are not supposed to have all your money in a speculative instrument like NUGT or DUST, there is no advantage in playing these instruments unless you are day trading. The slippage for position traders in triple leveraged ETFs will destroy any hope for profits. Anyone who bought and held NUGT since the beginning of trading from December 2010 has lost all their money a couple times over and more. Thanks to multiple reverse splits, the effective issue price is now $1855, down to a current price of $56. It is down 97% since inception nearly 3 years ago!

Setting Up a Fun IRA Trading Account That Does Not Go Broke Playing DUST Or NUGT, Etc.

Suppose I had $100,000 in my IRA. I would only use 40% of the funds for speculative plays like DUST or NUGT, or $40,000. While trading DUST, of the $40,000, I would put an initial $20,000 in DUST and keep $20,000 for backup. Why? Because DUST is triple leveraged. If GDX goes up 10%, then DUST falls 30%. If GDX has a rally of 33% straight up, then I would lose 99% of my investment in DUST. You cannot recover from that loss without adding more funds. The extra $20,000 is there to bail you out.

What we soon forget when playing DUST or NUGT, is the fact that they are triple leveraged. So if you buy 100 shares of DUST or NUGT, you are going to gain or lose as if you owned 300 shares of GDX. Owning 500 shares equals 1500 shares of GDX. That is scary!

Conclusion: Play Small & You Will Have A Ball!

That statement says it all! Play small and you will have a ball. Be a pig and you will lose really big! Bank on it!

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