I analyze macroeconomic issues from a fundamental perspective, and I analyze market behavior from a technical perspective. Original macroeconomic analysis can be found here and both macro analysis and commentary can be found on my Caps blog. If you like or appreciate my analysis, please add yourself to my Following List

Thursday, February 4, 2010

Volatility Decay of Leveraged ETFs - Another Study

I discussed Volatility in my recent post: Volatility Schmalatility, and I think volatility will be increasing substantially in 2010. This will certainly affect options pricing and Leveraged ETF performance (which is the point of this post)

First, you might ask "What is Volatility Decay"?. My friend anchak put together a fabulous comprehensive post on the subject and how it relates to leveraged ETFs. If you have not read and recced his original post, please do so now: 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

The *very* short explanation (you can go to any number of sites, or just read anchak's post above for the detailed explanation) is: Option values / strike prices are based on a number of factors, but primarily it is time and volatility. There is the volatility of the issue in question and there is also the volatility environment of the market (implied volatility). This VIX is one general measure of IV.

And if you haven't wondered before (which hopefully you have before you traded these instruments) how leveraged ETFs work (how they get 2x / 3x / etc. performance of the underlying index), it is through options. Being an engineer, I think of it this way: the ETF is trying to track the underlying index by buying puts/calls. However there is always some premium on the option from volatility (each option purchase is an "inefficient" representation of how market is moving - options are bets and there is always a premium on every bet that is magnified by volatility), and any inefficient process has entropy. Essentially, Volatility Decay is the "Entropy" associated with making inherently inefficient option purchases to track an underlying index.

Again, this is the very short version, please read anchak's post for the detailed version.

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 have said this many times and this is why I lay out my portfolios in very specific ways, as I discussed most recently in this post: What To Look For As a Long Term Trend Change Confirmation


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


Leveraged ETFs are a great way to trade the short term trends. They are NOT investments! (... okay, I think I have beat that dead horse enough)

The study I will show below that depicts Volatility Decay and some return comparison was adapted from one I did about a year ago in the CIL (I believe Mark910 and I were discussing this issue then). I brushed off the charts and added some trendlines to show you the phenomenon is real and why you need to be careful with them.

The next chart shows the performance of a 3x leveraged pair (in this case TNA and TZA) and asks the question: Is there a way to make the volatility work in your favor?

The answer I come up with is: No. Volatility robs performance no matter which way you slice it. The benefit you get by going short a long ETF eventually gets overcome by the fact that it is still a short sale, and your maximum gain is 100% and any gain (including volatility decay) is scaled against that 100%.

If you just want to play straight up volatility, VXX is your best bet (but since it is an ETN, it is *NOT* a good bet with a large portion of your real life money. Small bets are advised only)
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