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This is just some notes with no conclusion, moral at the end, or recommendations. Based on my experiments with leveraged funds over the last couple of years. These are things you only learn by doing and not by being an armchair investor. Have the battle scars to prove it. Just sharing.
Started with $60k in a separate account as play money to experiment and learn. Small enough to not be much consequence if I lost it all but big enough that emotional factors of losing come into play which is an important factor in investing.
The account quickly went down to about $40k in my early experiments and is currently above $70k. All of this in a bull market in the last two years. 20% over two years may not seem much but climbing back from losing a third required some fast learning and adjustments and so the later attempts have been much more successful. These comments are based on that.
First, the term leverage. This term has a lot of baggage. People bring out crosses and garlick when they hear that term. And yet the biggest channel of investment for most people is a highly leveraged play - real estate that one purchases with a mortgage with a small down payment and without a guarantee that they are going to live there for a long time. This can be as high as 20x and yet people knee-jerk to a 2x leveraged ETF.
The main difference is volatility and the structure of the typical leveraged funds tied to indices. Leveraged funds use futures and options. To provide liquidity they have to keep duration short and roll it over so they try to track daily moves and not long term performance. This has been well documented. The underlying index may have a strong upside return and yet a leveraged fund of that index can have negative results.
This characteristic is why leveraged funds get such a bad rap. But it is a tool. Like any high performance tool, it must be understood, respected and used for the right job.
Leveraged funds are recommended as short term trading instruments rather than longer term holdings. This is for the reason stated above. It is true that they are not buy and hold type of instruments but they are not a tool for day trading or as it is called wiggle trading to exploit small movements in indices either. At least not for retail investors trading without HFT platforms at very cheap fees.
This is how I quickly lost money. Leveraged funds going against the market can lose value quickly, so waiting for a turn around is not a viable strategy. They are extremely sensitive to volatility. So, the first lesson is don't play with leverage with highly volatile classes.
There is a myth that you should not buy ETFs that don't have decent daily volume. The rational is that spreads tend to be high and subject to manipulation. This is not true as long as the ETF is tied to very liquid, low spread asset classes underneath like the major indices.
There is much talk about the term "decay" in leveraged ETFs. Part of it is the characteristic mentioned above on how they track and part of it is from the compounding effect. But the latter works to your advantage when you have the direction right and so in low volatility movements up or down, leveraged etfs in that direction can provide more than their daily tracking multiple of 2x or 3x just as they can lose if in the wrong direction. But the two charactetistics are often confused.
It is impossible to predict the movements in a market as people know to any level of accuracy especially short term and so anyone claiming to make money from trading small wiggles in the market up or down isn't giving you the whole truth.
So, one has to use a probabilistic method to increase the chances of success and to be in the sweet spot which is having the right direction funds in a long bull or bear market. This is where leveraged funds make a lot of money, ironically with long term holdings in that period.
The problem is that markets are unpredictable and the approach is highly sensitive to entry points and to a much smaller extent to exit points.
This implies you need a good plan for entry and have an exit plan always using stop limits. This doesn't prevent losses but limits them.
The second learning is that leveraged funds are not instruments to be fully invested at all times. Many are misled as I was by thinking that since there are both long and short leveraged funds, you can switch back and forth and be fully invested at all times. This results in steep losses. The key is to wait for the right moment to enter, make money and get out when the market says so. But finding such moments aren't easy or foolproof of course.
There are two approaches to this. One is base it on some fundamentals such as overvalued markets, or expected economic conditions - increasing interest rates, for example. In my experience, this doesn't work. As they say markets can stay irrational longer than you can stay solvent.
The second is to base it on Technical Analysis. TA has a lot of cult behavior behind it and is good or evil depending on who is talking. In my experience, you cannot do any leveraged fund entry decisions without some kind of reliance on TA. Personally, I don't find any voodoo magic in TA or some mystical powers to predict. It is simply a tool that works as self-fulfilling prophecy primarily because so many people, retail and institutional use it, and nothing else.
One can see the effect of this in simple resistance and support level behavior of major indices. The indices bounce off of these things as if they were some mysterious oracles.but they do so only because enough people believe in them to make their buy and sell decisions for lack of anything else to base it on. This is my reading of it. This is typically what happens when there is very little new news to move markets. But they are not absolute.
Market moving news or sentiment can break those and regularly do but they provide more insight to market behavior than anything else. People get way too much into this with all kinds of pattern detection, which I think is mostly nonsense unless enough people believe it in which case it becomes a self fulfilling prophecy.
But simple is better and one doesn't need more than moving averages and standard deviation bands to get a sense of where the market is moving at the moment. All you are trying is not to do entries against the tide, so to speak. The volatility metrics also help in deciding on where to place stop limits. Otherwise, too tight a stop limit will stop out your position too soon, too far would increases losses if the market turned against your direction.
This simple reliance was enough to turn the performance around from my initial experiments. Which TA indicator to use is not that simple to answer because it depends on the fund and how frequently you want to trade.
Barchart.com is a site that provides some empirical data for various technical indicators but you need to do a free registration to access that part of the site. It is useful to do so if you do any kind of TA or are curious. It keeps track of a hypothetical trade at each signal for each indicator for each fund over time and displays average time between trades and the cumulative gains or losses by doing so. You will notice that many indicators result in losses for many funds while some require more trading than others, So, it is necessary to customize what you use for each specific fund and the duration of holding you prefer, for example 60 days in my case.
The consequence is that I mostly sit out of the market most of the time because neither long nor short leveraged funds can make money when the market is swinging up and down but there are periods in which it is like being on a fast elevator with many trades that get stopped out with small losses but overall gains in such periods.
Like I said at the beginning, there is no conclusion or moral or recommendation at the end of the story. Just a travelogue.
Comments
Started with $60k in a separate account as play money to experiment and learn. Small enough to not be much consequence if I lost it all but big enough that emotional factors of losing come into play which is an important factor in investing.
The account quickly went down to about $40k in my early experiments and is currently above $70k. All of this in a bull market in the last two years. 20% over two years may not seem much but climbing back from losing a third required some fast learning and adjustments and so the later attempts have been much more successful. These comments are based on that.
First, the term leverage. This term has a lot of baggage. People bring out crosses and garlick when they hear that term. And yet the biggest channel of investment for most people is a highly leveraged play - real estate that one purchases with a mortgage with a small down payment and without a guarantee that they are going to live there for a long time. This can be as high as 20x and yet people knee-jerk to a 2x leveraged ETF.
The main difference is volatility and the structure of the typical leveraged funds tied to indices. Leveraged funds use futures and options. To provide liquidity they have to keep duration short and roll it over so they try to track daily moves and not long term performance. This has been well documented. The underlying index may have a strong upside return and yet a leveraged fund of that index can have negative results.
This characteristic is why leveraged funds get such a bad rap. But it is a tool. Like any high performance tool, it must be understood, respected and used for the right job.
Leveraged funds are recommended as short term trading instruments rather than longer term holdings. This is for the reason stated above. It is true that they are not buy and hold type of instruments but they are not a tool for day trading or as it is called wiggle trading to exploit small movements in indices either. At least not for retail investors trading without HFT platforms at very cheap fees.
This is how I quickly lost money. Leveraged funds going against the market can lose value quickly, so waiting for a turn around is not a viable strategy. They are extremely sensitive to volatility. So, the first lesson is don't play with leverage with highly volatile classes.
There is a myth that you should not buy ETFs that don't have decent daily volume. The rational is that spreads tend to be high and subject to manipulation. This is not true as long as the ETF is tied to very liquid, low spread asset classes underneath like the major indices.
There is much talk about the term "decay" in leveraged ETFs. Part of it is the characteristic mentioned above on how they track and part of it is from the compounding effect. But the latter works to your advantage when you have the direction right and so in low volatility movements up or down, leveraged etfs in that direction can provide more than their daily tracking multiple of 2x or 3x just as they can lose if in the wrong direction. But the two charactetistics are often confused.
It is impossible to predict the movements in a market as people know to any level of accuracy especially short term and so anyone claiming to make money from trading small wiggles in the market up or down isn't giving you the whole truth.
So, one has to use a probabilistic method to increase the chances of success and to be in the sweet spot which is having the right direction funds in a long bull or bear market. This is where leveraged funds make a lot of money, ironically with long term holdings in that period.
The problem is that markets are unpredictable and the approach is highly sensitive to entry points and to a much smaller extent to exit points.
This implies you need a good plan for entry and have an exit plan always using stop limits. This doesn't prevent losses but limits them.
The second learning is that leveraged funds are not instruments to be fully invested at all times. Many are misled as I was by thinking that since there are both long and short leveraged funds, you can switch back and forth and be fully invested at all times. This results in steep losses. The key is to wait for the right moment to enter, make money and get out when the market says so. But finding such moments aren't easy or foolproof of course.
There are two approaches to this. One is base it on some fundamentals such as overvalued markets, or expected economic conditions - increasing interest rates, for example. In my experience, this doesn't work. As they say markets can stay irrational longer than you can stay solvent.
The second is to base it on Technical Analysis. TA has a lot of cult behavior behind it and is good or evil depending on who is talking. In my experience, you cannot do any leveraged fund entry decisions without some kind of reliance on TA. Personally, I don't find any voodoo magic in TA or some mystical powers to predict. It is simply a tool that works as self-fulfilling prophecy primarily because so many people, retail and institutional use it, and nothing else.
One can see the effect of this in simple resistance and support level behavior of major indices. The indices bounce off of these things as if they were some mysterious oracles.but they do so only because enough people believe in them to make their buy and sell decisions for lack of anything else to base it on. This is my reading of it. This is typically what happens when there is very little new news to move markets. But they are not absolute.
Market moving news or sentiment can break those and regularly do but they provide more insight to market behavior than anything else. People get way too much into this with all kinds of pattern detection, which I think is mostly nonsense unless enough people believe it in which case it becomes a self fulfilling prophecy.
But simple is better and one doesn't need more than moving averages and standard deviation bands to get a sense of where the market is moving at the moment. All you are trying is not to do entries against the tide, so to speak. The volatility metrics also help in deciding on where to place stop limits. Otherwise, too tight a stop limit will stop out your position too soon, too far would increases losses if the market turned against your direction.
This simple reliance was enough to turn the performance around from my initial experiments. Which TA indicator to use is not that simple to answer because it depends on the fund and how frequently you want to trade.
Barchart.com is a site that provides some empirical data for various technical indicators but you need to do a free registration to access that part of the site. It is useful to do so if you do any kind of TA or are curious. It keeps track of a hypothetical trade at each signal for each indicator for each fund over time and displays average time between trades and the cumulative gains or losses by doing so. You will notice that many indicators result in losses for many funds while some require more trading than others, So, it is necessary to customize what you use for each specific fund and the duration of holding you prefer, for example 60 days in my case.
The consequence is that I mostly sit out of the market most of the time because neither long nor short leveraged funds can make money when the market is swinging up and down but there are periods in which it is like being on a fast elevator with many trades that get stopped out with small losses but overall gains in such periods.
Like I said at the beginning, there is no conclusion or moral or recommendation at the end of the story. Just a travelogue.