3x ETF Decay Guide – Everything You Need To Know
Welcome to this guide. Here, I will be going over what you need to know to be prepared on how to successfully trade 3x ETFs. Moreover, I will explain what is 3x ETF decay in the simplest way possible. These 3x triple leveraged Exchange Traded Funds are infamous and controversial, to say the least. Some even claim that they are basically scams. While this is not really true, there are some risks and dangers when trading these 3x ETFs that you should be aware of before getting into them.
In Truth, these ETFs should not be touched by inexperienced traders; it just won’t work. Unfortunately, trading these triple leveraged ETFs without proper technical analysis skills and general market knowledge will end very badly. As I explain later in this post, the losses compound quickly in these financial instruments. We can now move on to the pros and cons like 3x ETF decay.
Pros of trading 3x ETFs:
Leveraged gains without the need for a margin account
These triple leveraged ETFs allow a trader to achieve 3x the movement that happens in the underlying in theory. There’s a bit of a catch to this that I will explain in the “Cons” section of this post. For example, if there is a 3x leveraged ETF like NUGT that tracks gold miners, and the mining companies stock that the fund holds goes up 3%, then NUGT should go up (approximately) 9%. This is great for traders who don’t want to short sell on margin, as they can buy 3x ETFs that short something like oil. This also allows traders to receive potentially leveraged gains without trading options. In short, if you know what you’re doing, you can boost your returns significantly.
This is a bit misleading, but it is true that if the ETF goes up for two or more days in a row (or have at least much more up days than down days volatility excluded), you will start to rapidly compound your profits. For instance, if you hold a 3x ETF for a few consecutive up days, you will actually receive more than three times the movement of the underlying derivative . So, yes, big gains are possible with these tools.
Less risk exposure
As mentioned previously, before the existence of leveraged ETFs, the only way to receive leveraged gains was with options and a couple of other instruments that often involve margin and very high risk where one could easily lose all of one’s investment. Obviously, these three times ETFs are not without a relatively high amount of risk, but still less risk than most alternatives.
Moving on to the “Cons”…
Cons of trading 3x ETFs:
Large losses that can compound fast
Like I said, depending on if the ETF has multiple up days, you can receive more than three times the returns compared to the underlying derivative. However, this can also be said for the downside. This means you can start losing more than three times the drop in the price of the underlying derivative. Moreover, these 3x ETFs can move sharply. For example, 10%, 15%, 20%+ losses can come quickly and seemingly out of nowhere.
3x ETF Decay
Sadly, leveraged ETFs are far from perfect. This is largely due to 3x ETF decay and the impact of volatility and fees on longer time frames (meaning not just a couple days). What happens is that the instruments start to lose triple leverage. In other words, holding these tools for longer periods of time will result in serious losses in most cases. Thus, it is important to note that leveraged ETFs are mostly made to day trade or for very short term trading. Long term, most of these triple leveraged ETFs will lose most, if not all, of their value.
As an example, take a look at the graph below of the popular Direxion Daily Gold Miners Bull 3X ETF (NUGT).
As you can see, the instrument lost almost all of its value in just a couple years due to 3x ETF decay. This is not a unique scenario, many of these leveraged ETFs show similar courses.
Experience is key for success
In essence, you have to know how to day trade in order to play with these ETFs successfully. This means that you have to be able to be competitive in technical analysis skills, fast timing/execution, good risk management, and so forth. If you don’t know exactly what you’re doing with these instruments, you risk serious losses. Furthermore, you have to be well informed and educated on the price movement of the underlying derivative. Therefore, if you’re trading an oil ETF, you’d better know what’s going on technically and fundamentally with oil.
Since most of these ETFs will fail and lose most of their value. Remember, for the instrument to stay afloat, the company that made the ETF will have to perform reverse splits. This usually happens when the price of the ETF is very low. Meaning, on its way to zero. That is, reverse splits will cause you to lose a significant amount on the trade. I think it’s time for some positivity. Up next, 3x leveraged ETF tips.
3x ETF Tips and Tricks:
- Use a stop loss to prevent large losses. Because of the sizable fast moves, you have to manage risk accordingly.
- When trading leveraged Exchange Traded Funds, use limit orders to avoid getting filled at poor prices due to sharp fluctuations in price.
- Avoid trading 3x ETFs when the price is low, i.e. a couple of dollars, because this is typically when reverse splits happen. Of course, one can’t predict when they happen, but better safe than sorry.
- Always do your technical or fundamental analysis on the underlying derivative, not on the leveraged ETF itself.
- Never try to predict moves or bet that something that will happen. Leveraged ETFs are reactionary tools.
- Never trade these instruments for more than a couple days because of the 3x ETF decay. The only exceptions are for things like SPXL, where the underlying derivative will usually go up, but even then, short term trading is better.
- Know how to day trade before getting into 3x ETFs.
In closing, keep learning, be careful, and best of luck!