Leveraged Exchange Traded Funds (ETFs) such as FAZ, FAS, and SKF are designed to multiply the DAILY PERCENTAGE change of the underlying index by factors of 2 or 3. They are thus toxic to your wealth and must not be held. Here’s a simple explaination of why. Take the FAS which is the 3X of XLF, the Financials fund. When XLF rises 1% in a day, the FAS is supposed to rise 3%. When things are going your way, everything is fine. But when the XLF drops, very bad things happen to FAS.
Have a look at this table:
On day 1, XLF rose 10% so FAS rose 30%. Great, you’re in the money.
But on day 2, XLF dropped back down to its starting price of $10.00, a decline of 9.09%. The bad news is that FAS declined 3X this amount or -27.27%. This takes its share price down to $9.45 instead of the $10 that you might expect.
So whereas XLF is unchanged after 2 days, FAS is down 5.45% after those same two days.
Why? The power of daily compounding instead of cumulative compounding. The leveraged ETFs are structured in a way that they compound on daily percent changes, not cumulative price changes. The day 2 decline of FAS should only be 23.08% to take it back to its original $10.00 per share price. But because it is 3X of XLF’s daily change, instead it declines 27.27%.
Said another way, the leveraged ETFs operate on the daily percent change not on the price of the underlying index.
Definitely not a buy and hold type of ETF! Not even for one day. Traders: set tight stops!
