1 The rebalancing rules of leveraged and inverse etfs are in the same direction as the immediate past movement of the underlying. If underlying moved up, they buy more; if underlying moved down, they all sell more.
2 They do a decent job in replicating X times the DAILY returns of the underlying, X being the leverage factor (ie X=2, 3, -1, -2, -3);
3 Due to the rebalancing rule, leveraged etf will OUTPERFORM, ie return you more than X times the underlying returns over multiple days, if the underlying is trending, which is similar to compounding effects;
4 However if the underlying is consolidating, then leveraged etf will buy high and sell low, which leads to time decay. The faster the underlying moves (volatility), and the more directionless the underlying moves (negative correlation over time), the faster the time decay. The effect is similar to theta of option, and the term "time decay" comes from that literature.
5 The behavior of leveraged ETFs are also like that of option. As an option moves further and further into the money, the long position gains at an increasing speed due to positive gamma.
6 Time decay of leveraged per se is not a problem. Time decay is a cost you pay to gain convexity, ie compounding effect. The problem here is that market on average is more likely to be trading in range/directionless/mean reversting (80% of time) than trading in momentum/trending (20% of time). So if you plan to hold for multiple days, then leveraged ETF is not a good instrument.
7 If you do want a long-term position, but still need leverage what do you do? You can use futures to gain leveraged without suffering time decay. You can also use the underlying (ie X=1) with margin money. With a portfolio margin account, you can go up to 6-7X leverage with minimal margin interest payment at today's low FF rates. The key here is to keep notional exposure in check. On a return on capital basis, you will gain 5X, 10X, 20X leverage. However the multiplier will be a linear multiplier, ie you will not gain compounding. Do not use options, as options are non-linear contracts that are best reserved to trade the direction of volatility, not the direction of the underlying.
8 If you do not understand the points above, do not touch either leveraged etf or futures. Options certainly should also be out of your consideration.
Just my 2c.
2 They do a decent job in replicating X times the DAILY returns of the underlying, X being the leverage factor (ie X=2, 3, -1, -2, -3);
3 Due to the rebalancing rule, leveraged etf will OUTPERFORM, ie return you more than X times the underlying returns over multiple days, if the underlying is trending, which is similar to compounding effects;
4 However if the underlying is consolidating, then leveraged etf will buy high and sell low, which leads to time decay. The faster the underlying moves (volatility), and the more directionless the underlying moves (negative correlation over time), the faster the time decay. The effect is similar to theta of option, and the term "time decay" comes from that literature.
5 The behavior of leveraged ETFs are also like that of option. As an option moves further and further into the money, the long position gains at an increasing speed due to positive gamma.
6 Time decay of leveraged per se is not a problem. Time decay is a cost you pay to gain convexity, ie compounding effect. The problem here is that market on average is more likely to be trading in range/directionless/mean reversting (80% of time) than trading in momentum/trending (20% of time). So if you plan to hold for multiple days, then leveraged ETF is not a good instrument.
7 If you do want a long-term position, but still need leverage what do you do? You can use futures to gain leveraged without suffering time decay. You can also use the underlying (ie X=1) with margin money. With a portfolio margin account, you can go up to 6-7X leverage with minimal margin interest payment at today's low FF rates. The key here is to keep notional exposure in check. On a return on capital basis, you will gain 5X, 10X, 20X leverage. However the multiplier will be a linear multiplier, ie you will not gain compounding. Do not use options, as options are non-linear contracts that are best reserved to trade the direction of volatility, not the direction of the underlying.
8 If you do not understand the points above, do not touch either leveraged etf or futures. Options certainly should also be out of your consideration.
Just my 2c.
