In part one, I set the economic backdrop behind the method. In part two, I’ll describe the the first part of the method, and then later, in part three, the mathematics of why it’s so effective.
As a disclaimer, knowledge in option trading, ETFs, and short selling is required. All relevant information can be found on Google.
To make in the market, one typically goes ‘long’ the underlying stock or index fund. For this write-up, I’m only going to discuss ETFs (exchange traded funds). Some examples of ETfs include the SPY, a proxy for the S&P 500, and TLT, a proxy for the 30-year treasury bond market.
Over the past 16 months or so, the S&P 500 has posted gains of around 2%:
However, this does not include the generous dividend yield, which is around 2% a year. Although this may not seem like much, over many years it ads up:
Reinvesting the dividends yields superior returns to the just the index itself.
However, there are ways to get even better returns, such as the use of leverage through options or futures. Another way is to use a margin account, in which you borrow money from the broker in order to increase your purchasing power.
A third way is to go ‘long’ a leveraged version of SPY, such as the SPXL, which tracks a the daily movements of the S&P 500 but magnified by three. That means if the SPY (the 1x version) is up 1% for the day, the 3x version will be up 3%.
There also exist leveraged version of bond funds, such as TMF, which is 3x version of TLT (30-year treasury bond). Other examples of leveraged S&P 500 funds include SSO (a 2x fund) and UPRO (another 3x one).
This is where things get tricky. The return of leveraged ETFs is path dependent, and different paths can result in the ETF deviating from the underlying index it is supposed to track. This is described in more detail here.
For example, consider the S&P 500 is up 1% on Monday and down 1% on Tuesday. The 3x version, SPXL, will be up 3% and then down 3%. Now repeat this a bunch of times: [(.97)(1.03)]^(t)]. For large ‘t’ it’s apparent this expression converges to zero.
If the path is unfavorable, 3x and 2x ETfs may lag the underlying index, especially if the daily moves for the underlying index are very large. Also, leveraged ETFs don’t pay dividends. But the S&P 500 and treasury bond market typically doesn’t make very large moves (at least not compared to commodities and small cap stocks), so this should not be a big problem. 3x etfs can offer offer significantly magnified returns if the path is favorable.
But because the stock market tends to spend a lot of time churning (as you can see in 2015), 3x ETFs tend to slowly decay. Stock market gains are often interspersed between months or even years of churning.
But there is another type of leveraged ETF that is much better, which I will discuss in part three.