The Leveraged ETF Misconceptions And How to Exploit Them Michael Julian 12/2/2013

The intent of this study is to explain a flaw in the market consensus regarding leveraged ETFs. First, I will explain levered ETFs, and the environment that causes them to underperform or outperform their target index. I will convey what I perceive as the markets intuition about these securitiesan intuition distorted by semi-true rhetoric and mathematic hypotheses regarding the future. I will then explain the volatility structure that these securities (specifically NUGT and DUST) trade in, why I believe the securities trade in this structure, and how to exploit it in a trade that has an extremely advantageous risk:reward outlay. I decided to write this piece after an hour-long debate regarding leveraged ETFsanother lesson that market opinions differ and information about securities is far from perfect. (1) Leveraged ETFs Leveraged ETFs are securities that target the returns of an underlying index with an exposure of 200 to 300%. Meaning, if an underlying index (SPX) rises by 1%, the +3x ETF, $SPXL will theoretically rise 3%. Conversely, the inverse ETF $SPXS, will fall by 3%. The returns are fairly accurate on a daily basis, and this is the most important caveat: Prospectuses of the leveraged ETFs warn investors to not hold for long periods of time, as the leveraged securities will tend to underperform the underlying index. How Leveraged ETFs Can Simultaneously Produce Negative Returns: Volatility in the index will erode returns on the ETFs. Let us observe a hypothetical environment, where an underlying index moves up and down, meeting (nearly) the same price after 8 periods.

Day 0 1 2 3 4 5 6 7 8 Total Return Effective Beta

Underlying Index Index Daily Price Return $100.00 $103.00 $99.91 $102.90 $99.82 $102.80 $99.73 $102.70 $99.64 -0.36% 1x 0% 3% -3% 3% -3% 3% -3% 3% -3%

3x Leveraged ETF Daily Return 0% 9% -9% 9% -9% 9% -9% 9% -9% ETF Price $100.00 $109.00 $99.19 $108.10 $98.39 $107.20 $97.59 $106.40 $96.80 -3.20% 8.89x

3x Inverse ETF Daily Return 0% -9% 9% -9% 9% -9% 9% -9% 9% ETF Price $100.00 $91.00 $99.19 $90.26 $98.39 $89.53 $97.59 $88.81 $96.80 -3.20% 8.89x

As observed, the up-and-down movements of the index are magnified. Because the returns oscillate around the original price, the positive and inverse levered ETFs will underperform. Levered ETFs have been branded as a bad long-term investment, and rightfully so. But this idea has been taken to the extreme. When searching leveraged ETF strategies on SeekingAlpha, you will come across various titles like, Shorting Leveraged ETFs to Profit in Any Market, and A Strategy for Shorting Leveraged ETF Pairs. Generally, for both inverse and positive levered ETFs to both underperform the underlying index, or have negative returns over a time period, the index must return to the original price. Unfortunately, not all indices are mean-reverting. In fact, markets are largely driven by trends.

How Long Positions in Levered ETFs Can Produce Positive Returns:

Underlying Index Index Daily Price Return 0 1 2 3 4 5 6 7 8 Total Return Effective Beta $100.00 $103.00 $107.12 $109.26 $108.17 $110.33 $114.75 $120.48 $116.87 16.87% 1x 0% 3% 4% 2% -1% 2% 4% 5% -3% 3x Leveraged ETF Daily Return 0% 9% 12% 6% -3% 6% 12% 15% -9% ETF Price $100.00 $109.00 $122.08 $129.40 $125.52 $133.05 $149.02 $171.37 $155.95 55.95% 3.32x 3x Inverse Daily Return 0% -9% -12% -6% 3% -6% -12% -15% 9% ETF Price $100.00 $91.00 $80.08 $75.28 $77.53 $72.88 $64.14 $54.52 $59.42 -40.58% (2.41)x

Day

As observed, the hypothetical index is in an upward trend. If we were to take positions in both the inverse and positive ETFs, the net gain would be (59.42+155.95 200.00) == $15.37, or a 7.685% hypothetical return. Im not a fan of hypotheticals; so let us observe the phenomenon in the S&Ps YTD Return, as of December 2, 2013. The S&P has risen approximately 30% over 11 monthsdefinitely a trend-driven market.

The results, taken from Google Finance, reveal that the +3x ETF SPXL has risen 101.51%, and the inverse ETF has fallen 57.00% If we took an equal position in both securities, the YTD return would be 22.25%. Trend-driven markets are more common than the ETF-shorters think. A position from Oct12 to Aug 13 in both inverse and positive gold ETFs would have returned around 215%. You would think with returns like these, traders would be drawn to taking long positions in both sides of leveraged ETFs. But time and time again, the lie is perpetuatedthe idea that an investor would be hopeless to try and find gains in holding leveraged ETFs in the long-term. A Look Into Option Prices Implied Volatility (IV) is a standardized gauge for the price of an option; its a more useful measure of relative value than the dollar price, because it takes into account a variety of factors like time, share price, and a forward-looking implication for volatility of the underlying. A higher IV denotes a more volatile underlying, and a higher relative price. I believe that the market consensus is revealed through the options volatility skew on these ETFs. The figure below depicts the volatility skew as of 12/2/13. The skew, which is usually depicted as a U-Shaped Smile, is actually relatively flat on NUGT and DUST. For this phenomenon to occur, ATM options must be bid up, and OTM options must be sold, as implied volatility is a function of supply and demand.

NUGT Volatility Skew LiveVol Pro This can happen a number of ways. Traders, under the impression that levered ETFs will always decay to 0, are buying ATM puts, or buying ATM put spreads. These trades push ATM IV upwards, and compress OTM IV, flattening the curve. Another reason may be that there are not enough traders competing in leveraged ETF optionsand misprices inevitably occur. A relatively flat skew creates trade opportunities that have a certain amount of edge. In this case, since ATM options are more expensive and OTM options are cheaper (both in IV and absolute dollar terms) we can create a short put spread on the ETF. A short put spread on a stock with little volatility will usually result in a return on risk of about 10-25%. However, an ATM short put spread on levered ETFs NUGT and DUST results in a maximum return on risk of 150%. A return on risk over 100% in a short spread is an interesting phenomenon that is generally present in options that trade at inflated IVs and/or flat skews. What is especially peculiar is that this opportunity exists on both the inverse and positive levered ETFs. I will offer a quick analogy:

The SF Giants are in the World Series versus the LA Dodgers. My friend Abe is a diehard Dodgers fanatic, and places the odds of the Dodgers winning at around 90%. Grace is a diehard Giants fan, and places the odds of the Giants winning at around 90%, too. Using this logic, they are both willing to individually engage in a bet with me: I bet Grace $100 that the Dodgers will win, and she will pay me $150 if I am right. I engage in the opposing trade with Abe. With 150% return on risk on both sides of the bet, I am perfectly poised to make riskless profit (counterparty risk aside of course. I dont trust Abe). The analogy is nearly perfect, with one exception: in the series, one team must win. In the market, both ETFs can lose, as we observed earlier in the study. That raises one last question, how much can we allow each ETF to lose over one year to break even? The Positions: NUGT POSITION PROFIT/LOSS

Source: Custom Graph on JMP v10, statistical software The first position consists of: (1) a short put at $25.00 strike; credit of $1,090 (2) a long put at $20.00, debit of $790 both dated to expire in January, 2015. The total position size is a credit of $300, with a maximum loss of $200. Its difficult to see, but the current price of NUGT is 26.81. Thus, the breakeven point at expiry is actually 22.00, 18% below the current price.

Current Price: 26.81 NUGT PROFIT/LOSS AT EXPIRY Stock Price P/L 18 $(200.00) 19 $(200.00) 20 $(200.00) 21 $(100.00) 22 $23 $100.00 24 $200.00 25 $300.00 26 $300.00 27 $300.00 28 $300.00 29 $300.00

Current Price: 48.90 DUST PROFIT/LOSS AT EXPIRY Stock Price P/L 28 $(210.00) 29 $(210.00) 30 $(210.00) 31 $(110.00) 32 $(10.00) 33 $90.00 34 $190.00 35 $290.00 36 $290.00 37 $290.00 38 $290.00 39 $290.00

The DUST spread consists of (1) a short put at $35.00; (2) a long put at $30.00 Total Position is a credit of $2.90. Originally, the spread was to be executed at 45/40, but the 35/30 provided the exact same risk:reward profile, at a much safer breakeven point.

As of 12/2/13, DUST trades at 48.90. The breakeven point for the short 35/30 put spread is 32.10, meaning DUST must drop at least 34% before January 15 for this position to begin losing money. Another important note: all options bought are quoted at the ASK price, and all options sold are quoted for the BID price, for instant execution. I have done this to stay conservative with profit estimates, and hold fast execution at high value. A non-hedged position on a levered ETF will cause trouble.