*Direxion*Knowledge Is Power When It Comes To Leveraged ETFs

Leveraged exchange-traded funds are arguably one of the most alluring asset classes on the market today. Novice traders can be seduced by a triple-leveraged ETF, such as the Direxion Daily Gold Miners Index Bull 3X Shares NUGT, delivering gains of 15 percent, 20 percent or more in single day.

Seeing such gaudy returns as that arrive in short order can lead the uninitiated to believe that leveraged ETFs are an easy money/free lunch opportunity. That is not the case. However, traders that have the risk tolerance for leveraged ETFs, which includes knowing that where a 20 percent intraday gain lurks a 20 percent one-day loss is also possible, can empower themselves while potentially increasing their odds of success with education.

Perhaps the most often repeated educational point about leveraged ETFs, and it bears repeating, is that these are not buy and hold instruments. There is a reason why, at least in the case of Direxion's leveraged ETFs, “daily” is found in the names. That reason is an ETF such as NUGT is designed to deliver triple the daily returns of its underlying index. Or in the case of inverse leveraged ETF, such as the Direxion Daily Gold Miners Index Bear 3X Shares DUST, those ETFs are designed to deliver double or triple the daily inverse returns of a particular index.

An example I've used before in conversation with those new to leveraged ETFs is to say “You know how Warren Buffett treats Coca-Cola Co. KO? Meaning he's basically held the stock for an eternity. Well, you should use the exact opposite line of thinking with a leveraged ETF.”

Proper use of leveraged ETFs comes from properly understanding the mechanics that makes these funds work, including daily rebalancing.

“Daily rebalancing has important implications for the performance of the funds for periods longer than a day,” notes Direxion. “Why? Daily Leveraged Funds exposure is a product of its target magnification and its net assets. Favorable moves in the benchmark push net assets higher, which translates into an increase in exposure by a multiple of the gain in its net assets.” 

Likewise, if a leveraged ETF's underlying index declines, the ETF's assets can decline, triggering “a reduction of exposure in an amount which is a multiple of the decline in the net assets,” according to Direxion.

The bottom line is that as an ETF like NUGT rises, it becomes more aggressive, but as it declines, it becomes more defensive. A hypothetical example requiring basic math illustrates the point.

Say NUGT has $100 million in assets under management (in reality, it is larger), it must maintain $300 million in exposure to the NYSE Arca Gold Miners Index. If the NYSE Arca Gold Miners Index drops by one percent in a day, NUGT's gross exposure would fall to $297 million, reducing its assets under management to $97 million. 

“Since 300% of $97 million equals $291 in exposure, the current exposure must be reduced by $6 million from $297 million to $291,” according to Direxion.

Another important point to note regarding the dangers of holding leveraged ETFs for long periods is the erosive impact directionless markets can have on these funds over multiple days or weeks. Put simply, a trader does not want to be holding a leveraged ETF, bull or bear fund, when the market in question can not establish a firm trend.

“In volatile markets that exhibit no clear trend or direction, the impact of daily rebalancing can be harmful to the performance of leveraged ETFs over time,” said Direxion. Leveraged ETFs “respond to gains by increasing exposure to the index, and respond to losses by decreasing exposure each day. Increased exposure in advance of a loss will generate a larger loss, and decreased exposure in advance of a gain will decrease the impact and benefit of future gains for the fund. A continued pattern of this sort will typically cause the decay of the longer term returns of the fund.”