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Trading Leveraged Funds

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Before we get started let's define what a leveraged fund is. A leveraged fund seeks to amplify the returns of the underlying index or etf that it follows. These funds generally seek returns of 2x or 3x the underlying, and they achieve this by trading financial derivatives like futures and options.

For example, QQQ is a very popular tech-heavy etf. TQQQ is an etf based on the QQQ but seeks a 3x return. Meaning if the QQQ goes up 1%, TQQQ should go up 3%.

What is the purpose of this? Why not just buy 3x more QQQ? The answer is leverage. A person might only be able to afford 100 shares of QQQ, but by buying TQQQ they can essentially own much more exposure with the same amount of money. That's leverage.

So where is the problem? Is there a problem?

There is no problem in the very short-term. Problems only appear as time goes by, and they are exaccerbated by large fluctuations (volatility) in the underlying instrument. Let's take a look at a chart of TQQQ.

QQQ is up 4%, while TQQQ is down 16%.

You can see QQQ is up 4% over this time frame, but somehow TQQQ is down 16%. If it's a 3x leveraged fund tracking QQQ it should be up 12%, right? Well that's the problem. When the underlying is moving in a nice orderly line, like the uptrend from the beginning of this chart until the highs in mid-February, TQQQ performed its function quite well. QQQ was up 18% while TQQQ was up 60%. A perfect 3x would have been 54%, so it was actually slightly outperforming its stated purpose.

But then the market fell, and it fell in a volatile way. Down sharply, then back up, down some more, back up one day, down the next. Within just a few short days TQQQ had begun to drop below the still positive QQQ return, and by the end of this chart on April 15th, two months from the time it had been following its 3x goal very well, it had collapsed to a point that it was a full 28% below where it should have been.

How does this happen? Surprisingly, it's simple math.

If a $100 etf were to go up 10% one day, and then down 10% the next day, how much would it be worth? $100? No. It'd be worth $99. Now what if that etf had a 3x leveraged counterpart? That would mean it would go up 30% one day, and down 30% the next day, leaving it worth how much? Just $91. That means that in just two days the leveraged etf was down 9% versus the underlying etf's drop of just 1%. It worked on day one perfectly, but by day two the whole concept had fallen apart.

Of course most etfs won't move 10% in a day, so the differences are not likely to ever be this dramatic, but over time, each little move adds up. Let's look at an example:

In this example you can see that after six days of trading, with QQQ going up and down a bit, but ending up about where it started, TQQQ actually underperformed QQQ. It should, in theory, have been 3x higher, for a return of 2.1%, but instead is up just .46%. It's because of this that leveraged etfs are suitable for short-term trading only.

Our suggestion is to be very selective with trading leveraged etfs, and to do so only with short-term movement in mind. If you want leverage, then options are likely a better choice for you. Also, never use a leveraged chart to determine a technical trade setup. Any charting should be done on the underlying instrument.



Wanderer Financial