Stock Market Student

A few weeks ago a light bulb switched on in my head;  well actually it was a CFL not an incandescent as the light was slow to come on and started out rather dim.  The idea has to do with leveraged ETFs.  Many of the companies providing these instruments are getting sued for not properly informing investors of the inherent dangers with them.

The reason they are "dangerous" is that they provide leverage (x2, x3, etc) on a daily basis but not long term.  Daily compounding results in significant skew from the underlying index.  Let's examine this a little closer by comparing the results of an underlying index versus a typical x3 leveraged fund.

Underlying

Start  100

Day 1  102  +2.00%

Day 2  100  -1.96%

Day 3  102  +2.00%

Day 4  100   -1.96%

Total  0%

Leveraged

Start  100

Day 1  106       +6.00%

Day 2  99.76     -6.24%

Day 3  105.75  +6.00%

Day 4  99.53    -6.22%

Total  -0.48%

As you can see from this simplified example, the non-leveraged index broke even over four days.  The index started at 100 and finished at 100.  Whereas the x3 leveraged fund lost 0.48%.  How can this be???  It is the simple result of daily compounding on a leveraged instrument.

The characteristics of leveraging are as follows:

- Long trend up or down without reversals will result in highly leveraged profits (or losses)

- Volatility will result in decreasing value regardless of long term direction.

- ALL leveraged ETFs will lose money over the long term.

With this in mind I decided to go about making a speculative stock system based on the long term degradation of leveraged ETFs.  I will explain more over the next few posts.

The DJIA broke 10,000 on the down side this morning and it remains to be seen whether this is the beginning of the end or the end of the beginning.   The index is hesitating around 9,950 (at noon).  Any real bad news could send the markets plummeting.  Or maybe this is one big manipulation by the big traders, driving the markets down to support levels and scaring away the little guys.  Great if you believe in conspiracy theories.

My gut feel says this is the beginning of the end ... and I have a pretty big gut.  At least my wife says so.

UPDATE:

I remember Larry Williams once say that traders always expect the big crash to happen and it never does.  (Well that's not completely true:  2007-2009 is a good example).  However, fear does play a big part in the stock markets.  So below is my reading of how the DJIA chart looks (5 year chart):

We are at a fairly significant cross-road as you can see by the red lines.  It is quite likely that fear will subside and the DJIA will rebound off the support level.  Or not.

Steve