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Using TWM as an example. Long term it looks very crazy. Like back in 2007 it was at $600 and now it is at $40. Let's say I have $10,000 in investing. My plan was to put $1,000 in something like TWM to offset my other investments. That way if we hit more bumps I'll be able to have something that is cutting back on the pain. My plan is if we hit another drop I'll sell TWM. I'm looking at TWM as a trade, not an investment. My other stocks are investments. This is a +/- 10% trade. I wouldn't expect to have TWM for more than 2 or 3 weeks and plan to auto-sell it if it drops 10%. Pretty standard stuff.

Everyone talks about how ETFs can kill you. Is there something other than the price that will kill me? I've got $1,000 in TWM. If TWM drops 10% I'll have $900... right? I won't have lost everything because of some daily compound interest fee calculation or whatnot? The ETF goes down, my investment goes down, the ETF goes up my investment goes up... correct? I'm very worried that at the end of the day some sort of fee is going to be leveraged against my account or something crazy is going to happen that'll zero out my account and force me to leap off the nearest bridge.

Edit: After doing some research it appears that long term ETF strategies tend to end poorly, almost like a radioactive half-life. This is especially true when dealing with 2x, 3x systems. There appears to be no other special gotchas for ETFs or Leveraged ETFs aside from a long term decay (and no promise of going up 30% just because it is a 3x). This exactly what I was expecting when I got into a Short ETF: I wanted something to deal with the volatility that has been plaguing the market without directly shorting stocks. My highest risk remains my $1,000 investment, no more. Loosing the entire $1,000 on TWM seems unlikely if I'm going to only hold it for the month of December. Please correct me if I am wrong.

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    I'm not sure I understand what do you mean by "Everyone talks about how ETFs can kill you"... Who talks? Why would ETF kill you? Are you implying that all ETF's are necessarily leveraged? That's not true, in fact most of them are not. – littleadv Dec 1 '11 at 21:23
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    Long term ETFs which have low fees, say the SPY (S&P) will track the index pretty closely. Such ETFs do not belong in the same category as the leveraged ones you reference. – JoeTaxpayer Dec 2 '11 at 4:14
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leveraged etf's are killer to hold because they seek to return some multiple of the DAILY price movement in an index.

so twm seeks to return 2x the daily move in the russell 2000

Let's trace this out assuming (just to make it easy) large daily moves, and that you start with $1000 and the russell 2000 starts at 100.

start of first day rusell 2000 == 100 you have $1000 end of first day (up 10% nice!) rusell 2000 == 110 you have $1200 end of second day (~9.1% down) russell 20000 == 100 you have $981.60

so the russell 2000 can move nowhere and you have lost money!

This doesn't apply to all etf's just leveraged etf's. You would be better buying more of a straight inverse etf (RWM) and holding that for a longer time if you wanted to hedge.

  • This is great, thank you! One question - when I look at the 3 big ones (RWM, TWM, TZA) they all look the same (just with bigger ups and downs depending when you go 2x or 3x). In each case all 3 stocks are about flat with their lows in July (TWM 39 vs 40, TZA 30 vs 28, RWM 28 vs 30). If I invested $1000 in EACH of these three stocks in July and sold them today I would expect a flat return (looking at a +/- of 3%). Is that true? This is where I'm worried the most. Does something else happen over this length of time that does not show up in the stock charts? – samwise Dec 2 '11 at 2:22
  • I am not sure exactly what you mean. Take a look at the following chart. google.com//… You can see that the leveraged funds can outperform over the course of a few days if the markets put a few bad days back to back, but in general they outperform especially during volatile (a lot of up and down motion) periods. – Pablitorun Dec 2 '11 at 3:45
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Don't put money in things that you don't understand. ETFs won't kill you, ignorance will. The leveraged ultra long/short ETFs hold swaps that are essentially bets on the daily performance of the market. There is no guarantee that they will perform as designed at all, and they frequently do not. IIRC, in most cases, you shouldn't even be holding these things overnight.

There aren't any hidden fees, but derivative risk can wipe out portions of the portfolio, and since the main "asset" in an ultra long/short ETF are swaps, you're also subject to counterparty risk -- if the investment bank the fund made its bet with cannot meet it's obligation, you're may lost alot of money.

You need to read the prospectus carefully.

The propectus re: strategy.

The Fund seeks daily investment results, before fees and expenses, that correspond to twice the inverse (-2x) of the daily performance of the Index. The Fund does not seek to achieve its stated investment objective over a period of time greater than a single day.

The prospectus re: risk.

Because of daily rebalancing and the compounding of each day’s return over time, the return of the Fund for periods longer than a single day will be the result of each day’s returns compounded over the period, which will very likely differ from twice the inverse (-2x) of the return of the Index over the same period. A Fund will lose money if the Index performance is flat over time, and it is possible that the Fund will lose money over time even if the Index’s performance decreases, as a result of daily rebalancing, the Index’s volatility and the effects of compounding. See “Principal Risks”

If you want to hedge your investments over a longer period of time, you should look at more traditional strategies, like options. If you don't have the money to make an option strategy work, you probably can't afford to speculate with leveraged ETFs either.

  • The daily re-balancing really confuses me. If I purchase a leveraged ETF on Monday at $30 and sell it on Friday for $27 I have lost 10% correct? No matter what has happened between those two times. If I buy a leveraged ETF in June of 2006 for $30 and sell it in July of 2044 for $27 I've still lost only 10%. Correct? No matter if it is an ETF, Leveraged ETF, 2x, 10x, 40x whatever. Daily re-balancing makes the Leveraged ETF much more volatile, but the ETF price is still the price. That's what I want to make sure about. – samwise Dec 2 '11 at 15:35
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    It does sound confusion but it isn't really. You are right the etf price is still the price, it is just what the etf is buying and selling internal to the price that makes up the volatility. duffbeer +1: one comment though, there is nothing particularly wrong with holding a leveraged etf overnight as long as you know the risks. A leveraged inverse etf will perform spectacularly if the index put in a few days of negative returns back to back, but volatility is the enemy and we live in an age of volatility so mostly I agree with you. – Pablitorun Dec 2 '11 at 15:58
  • duffbeer: actually rereading your answer I see that you say in most cases you shouldn't be holding them overnight, not all cases, so I agree with you entirely! another +1 if I could. – Pablitorun Dec 2 '11 at 16:03
  • Now I understand. I had picked it up yesterday at $39.50 and was really worried that even though it said $38.50 today that something more dangerous/sinister was going on (Like some sort of daily compound interest fee or something). That was my primary concern. Now I plan to let go of it EOD Monday if this rally keeps going till then (fingers crossed). Since my other stocks are up today it's only taking a small portion of the gains, so it is acting as I was hoping (a hedge). But holding it longer than Monday if we continue to have gains is a horrible idea. Ok. I'm good. THANKS guys!! – samwise Dec 2 '11 at 16:08
  • @Pablitorun Just keep in mind that if you hold it overnight, you are at risk. The fund is only trying to meet its objective... which is to model the market for the trading day. The fund managers do not care what happens beyond that -- which is very different than other investments. If you close the position daily, you are limiting your costs to the commission and capital gains. If you hold it beyond one day, you are exposing your entire investment to an unknown, unquantifiable risk. – duffbeer703 Dec 2 '11 at 17:03
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The fundamental issue with leverage (of any sort, really) is that the amplified downsides are extremely likely to more than cancel out amplified equivalent upsides.

Example without using a major swing: 2x leverage on a 5% decline (so a 10% decline). The 5% decline needs a 5.26% increase to get back level. However, the 2x leverage needs an 5.55% increase to get back. So a cycle for the unleveraged returns of -5%, +5.4% would see the unleveraged asset go up by a net +0.13% but 2x leverage would leave you at -0.28%. Conversely, imagine 0.5x leverage (it's easy to do that: 50% cash allocation): after an underlying -5%, the 0.5x leverage needs only +5.13% to reach par. This is basically the argument for low volatility funds.

Of course, if you can leverage an asset that doesn't go down, then the leverage is great. And for an asset with an overall positive compound return, a little leverage is probably not going to hurt, simply because there are likely to be enough upsides to cancel out downsides.

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That's not 100% correct, as some leveraged vehicles choose to re-balance on a monthly basis making them less risky (but still risky). If I'm not mistaken the former oil ETN 'DXO' was a monthly re-balance before it was shut down by the 'man'

Monthly leveraged vehicles will still suffer slippage, not saying they won't. But instead of re-balancing 250 times per year, they do it 12 times. In my book less iterations equals less decay.

Basically you'll bleed, just not as much. I'd only swing trade something like this in a retirement account where I'd be prohibited from trading options.

Seems like you can get higher leverage with less risk trading options, plus if you traded LEAPS, you could choose to re-balance only once per year.

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