Short-Term Traders: Beware This Flaw In Leveraged ETFs

I’ve written many articles and discussed several times that it’s unwise to buy and hold leveraged ETFs – unless you’re at a major support level or you catch an uptrend. Buying and holding through volatile periods results in erosion. In other words, if you hold a leveraged ETF during a period of sideways or consolidating action, there’s a very good chance that you’ll lose money – even if prices go nowhere. The following chart is one of the QQQ, with its corresponding 3x short ETF (SQQQ) and 3x long ETF (TQQQ). Check out this chart where the QQQ shows a lot of volatility, both higher and lower, but returns to a level from an earlier period. Also, look at what happens to the SQQQ and TQQQ in the panels below:

Let’s assume that we bought the QQQ at the low after the October CPI gap up on November 10th. From that day through just a few minutes ago, the QQQ gained roughly 1.4%. Now, if you were bearish and decided to short the NASDAQ 100 using the 3x leveraged SQQQ, you would expect that you’d be down 4.2% (1.4% move higher in the NASDAQ 100 times 3). But the SQQQ has actually dropped 8.9%. That’s 4.7% of “erosion” from the back and forth action.

Now how about if we wanted to benefit from that move higher in the QQQ by owning the leveraged 3x TQQQ? Well, we should be up 4.2%, right? But look at the chart. The TQQQ has been flat since the November 10th low. You’d have been much better off by simply buying the QQQ. Does this make sense? Actually it does, if you know how these leveraged ETFs work. They use derivatives to attempt to match the 3x calculation on a DAILY basis. They’re not designed to track 3x over any other time period. It’s the volatility and time elapsed that trigger the erosion of these leveraged ETFs. They can actually perform much better than 3x, however, if you catch a trend and it’s due to the compounding nature of these leveraged gains or losses.

When I trade leveraged ETFs, on the long side, for example, I typically try to catch them when the underlying security tests major support or makes a major breakout from a period of consolidation. I then hold them short-term so long as prices rise. I make sure I keep my stop in place and I try to avoid riding them up and down like a roller coaster.

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Happy trading!