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Volatility Decay: A New Kind of Risk


Shorting double- or triple-leveraged ETFs could be good long-term play.

The danger in holding double and triple ETFs has already been discussed in Minyanville, but these horses are nowhere near dead - they definitely need to be beaten again.

I'll call ETFs that are leveraged 2 or 3 times in either direction, long or short, LTFs. LTFs have an intrinsic feature never seen before in anything traded on exchanges. I call it "Volatility Decay" which if you do a Google search, it pretty much doesn't exist, so I think it hasn't sunk into very many people on The Street. Time decay in stock options is logical and intuitive. Volatility Decay is not and it needs to be fully explained before too many investors get hurt.

To paraphrase Toddo and Yogi, you can learn a lot by looking. So let's look at a 6-month daily chart of IYR and SRS.

IYR is the ETF that tracks the Dow Jones US Real Estate Index, and SRS is the double-bearish ETF of that same index. SRS peaked on November 21, 2008 at $295.72, when IYR hit $23.51.

Since November 21, 2008, IYR rallied and subsequently declined to a new closing low on March 6, 2009, at $22.31. Logically, then, SRS should have closed last Friday close to $300, right? Nope, it closed at $99.32. That, my friends, is Volatility Decay.

So what the hell is going on?
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No positions in stocks mentioned.

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