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Thread: Reminder of the Limitations of Leveraged (2X & 3X) Instruments

  1. #1
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    Reminder of the Limitations of Leveraged (2X & 3X) Instruments

    I am sure majority of the group here already knows this, but yesterday I was speaking with a friend who has over 20+ years of personal trading experience and much to my surprise he was not aware of this issue. So, I thought why not take a second to burn a thread and remind those who don’t about the limitations of leveraged (2X & 3X) instruments.

    I am sure almost everyone has heard that leveraged instruments should not be considered for buy-and-hold but rather utilized for day-trading only. Why? For this example, I am going to use round numbers and extreme moves to prove the point. In a perfect world, leveraged instruments are intended to magnify the close of the instrument by 2X or 3X (yes, I am aware that prices are driven by liquidity, bids and asks, etc. yet the underlying principle remains).

    Let’s pick a hypothetical index and start with $20K, where $10K will be placed in an account for a +2X ETF and $10K will be placed in an account for a +3X ETF.

    On Day 1 of holding, if the index INCREASES by 5%, the 2X account will be worth $11,000 and the 3X worth $11,500.
    On Day 2 of holding, if the index DECREASES by 5%, the 2X account will be worth $9,900 and the 3X worth $9,775.
    So, after two days, the index is back to where it started (0% change after 2 days) and yet your principal is less.

    You might be asking yourself, what if the index moved in reverse directions.
    On Day 1 of holding, if the index DECREASES by 5%, the 2X account will be worth $9,000 and the 3X worth $8,500.
    On Day 2 of holding, if the index INCREASES by 5%, the 2X account will be worth $9,900 and the 3X worth $9,775.
    Again, the index is back to where it started and your principal is less.

    What’s the moral of the story, leveraged instruments are dangerous to your principal in a sideways market. Full disclosure, I am guilty of the above as I also hold TNA since last Friday.

    So my goal here is to provoke some thoughts and possibly develop a trading strategy. My question to the group is “is there a better strategy to minimize risk when one wishes to leverage positions when the Robots issues ‘very strong’ signals?” Pascal has already talked about how the 20DMF is an early signal. Should we divide money allotted for the robot signals into thirds and used the 20DMF for the first 1/3 in a 1X instrument. Options are another way to capture leverage but I must admit I don’t know much about options. Paul Duncan’s methods seem promising (slope of slopes to confirm market trend) and maybe these should be utilized for the final 2/3 of the principal if one wished to add leverage (2X & 3X) positions? I have questions but no answers. Any ideas?

    Harry

  2. #2
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    Harry,

    note that even with no leverage, you end up with a smaller capital: 0.95 * 1.05 = 0.9975.

    But if you're worried about the erosion of leveraged ETFs, I believe that a solution would be to use futures. In addition to solving this problem, it also presents these advantages:
    - you can pick the exact leverage you want,
    - you can trade it almost 24h a day, 5 days a week (which in turbulent times might be useful),
    - low bid-ask spread.

    2 inconvenients I can think of:
    - you can't use it if you have a small sum of money to invest (unless you use a dangerous level of leverage), each TF contract being worth a notional amount of ~$79K,
    - possible cost of rolling over positions.

    The usual disclaimer applies though: trading of futures contract may not be suitable for everyone and involves substantial risk, etc.

    Max
    Last edited by Maxime A.; 06-17-2011 at 06:58 AM.

  3. #3
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    Max,

    Thanks for the response and pointing out my glarring omission of the 1X loss. I was aware but chose not to focus on it since 2X & 3X are easier strawmen.

    Unfortunately for me, I am a very small fish and the overall amount I am confortable trading is less than or equal to one contract. So, futures are not an option for me.

    Harry

  4. #4
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    TZA & IWM Prospectus

    Harry

    For more info on the risks of leveraged (2x & 3x) Instruments I have attached the link to the TZA Prospectus.
    It is worth reading to fully understand how these instruments work.

    http://pe.newriver.com/em.asp?cid=ET...&fid=25459W110

    More specificaly: "Intra-Day Investment Risk — The Fund seeks leveraged investment results from the close of the market on a given trading day until the close of the market on the subsequent trading day. The exact exposure of an investment in the Fund intraday in the secondary market is a function of the difference between the value of the Index at the market close on the first trading day and the value of the Index at the time of purchase. The Fund’s gains occur as its market exposure declines and its losses are accompanied by increases in market exposure. If the Index declines, the Fund’s net assets will rise by an amount equal to the decline in the Fund’s exposure. Conversely, if the Index rises the Fund’s net assets will decline by the same amount as the increase in the Fund’s exposure. As an example (using simplified numbers), if the Fund had $100 in net assets at the market close, it would seek –$300 of exposure to the next trading day’s Index performance. If the Index declined by 1% by noon the following trading day, the exposure of the Fund will fall by 1% to –$297 and the net assets will rise by $3 to $103. With net assets of $103 and exposure of –$297, a purchaser at that point would be receiving –288% exposure of her investment instead of –300%."

    TZA does not have a direct intra-day correlation with IWM. Its is important to understand these differences.

    Also, here is the link to the IWM prospectus:

    http://pe.newriver.com/em.asp?cid=ET...&fid=464287655

    I hope this helps,

    Normand

  5. #5
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    Thanks Normand!

  6. #6
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    Quote Originally Posted by Harry View Post
    I

    My question to the group is “is there a better strategy to minimize risk when one wishes to leverage positions when the Robots issues ‘very strong’ signals?” Pascal has already talked about how the 20DMF is an early signal. Should we divide money allotted for the robot signals into thirds and used the 20DMF for the first 1/3 in a 1X instrument. Options are another way to capture leverage but I must admit I don’t know much about options. Paul Duncan’s methods seem promising (slope of slopes to confirm market trend) and maybe these should be utilized for the final 2/3 of the principal if one wished to add leverage (2X & 3X) positions? I have questions but no answers. Any ideas?

    Harry
    I just noticed this thread, Harry. Regarding the risk of distortions due to compounding, a simple strategy I like is to monitor your position compared to what it would be if it tracked the cumulative 2X or 3X percentage price change in the underlying ETF. When it gets out of whack by a certain percentage (say, 5-10 percent), add or sell shares to bring it in line.

    I hope this helps.

    Neil

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