The danger of Ultrashorts : the leverage game
The list of ultrashorts is a long long list. Here are the ones that I track personally
EEV,FXP,SCO,SCC,SMN,SSG,DXD,BGZ,DEE,DOG,FXB,FXF,MZZ,PLW,PSQ,QID,REW,RWM,
SDS,SH,SIJ,SKF,SKK,TZA,BND,DTO,DUG,DZZ,EFU,ERY,FAZ,MYY,SRS,TWM,SJH
This information is borrowed. Note : (Ultra longs have similar dangers!)
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The point of the Leveraged ETFs are increasingly becoming important as their popularity increases – both here and outside I am sure. The issue has definitely become magnified with the introduction of the Direxion 3x ETFs.
No Denying the Danger======================
I have actually used the phrase “Weapons of Wealth Destruction” against these ETFs. A lot of fools have realized their peril
These leveraged ETFs should be considered as derivatives and are dangerous like derivatives. There’s a small correction : THEY ARE DERIVATIVES , hence are AS DANGEROUS as derivatives. Ie for commonfolk that means Options.
And of course with Options: you risk only capital where you are ready to loose 100% ALL THE TIME. This is of course true of a lot of stocks in this meltdown .
Basics of Leverage======================
I think most of the people know what this is : the simplest example is the Home Loan Mortgage: You typically have 10% down payment – the bank lends you 90% and you own the house – well that is a 10: 1 leveraged transaction (10x) – you gain/loose 10 times of each 1% movement of the house.
Lets turn it around and look at it from an investor standpoint. Lets say what would be an easy run-of-the-mill way for an investor who owns his house “clean & clear” and wants to invest/speculate in real estate – and lets say the bank A. agrees to loan 100% of the value of his house – he can then easily buy “clean & clear” a house similar to his own and thus create a 2x leverage or of course he can go to 10 banks and do a 10% downpayment on 10 similar houses and thus be borrowed and doomed to the hilt.
Well that’s how it works in real-estate and in most physical markets , the issue of course is – by buying the 10 houses – the investor is bound to increase demand/supply imbalance and has to pay a little more with each transaction. This is really what stops Fundhouses from playing this the old way . If you had a 2x Exxon ETF : They can easily try borrow against your money and buy 2 shares for every 1 share of XOM you funded - but that would move XOM big time. Also there’s the problem of not many people will lend 100% against a XOM share. Additionally, these Leveraged ETFs are based on indexes , making this impossible to execute on all underlying scrips of the index.
So in comes Index futures,swaps,cash, treasuries. Basically using a blend of these 4 instruments ( 2 of which are Derivatives) you can create almost all “n”x leverages within rational bounds! And the great thing is notionally they do not move the underlying – but of course demand/supply has to affect something - and in this case , it’s a nice little thing called “Volatility Premium” which drives the price of the derivative itself. But there’s so much beauty ( ahh! Hmm! Cough! Splutter!) in these – since most of them are priced under sophisticated variants of the Black-Scholes model , the “Implied Volatility” which is what is actually used to price – can’t really diverge too much from the “Actual Volatility” displayed by the stock.
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More on this later friends