In this scenario, there is an outperformance when compared to the target index value at the end of the fourth day FAS should have been 144.16 and FAZ should have been at 55.84. Similar outperformance exists in a steady down-market as well.

Summary:

It is critical to understand the use of leverage and how it impacts the performance of the funds over a period of time. Since these funds track the performance of the associated index at 3 X (or inverse) leverage on a DAILY basis. it is not possible to mimic the performance of the associated index over a period of time. As the latter spreadsheets indicate, if one can guess the market direction correctly, the funds can provide outperformance over the period of time anticipated. Conversely, in a market that lacks direction, these funds are unsuitable.

The legitimate question that begs is if one can get 3X leverage using these funds, why not funds that have leverage 5X, 10X, 100X, etc. Presumably, one can strike gold overnight by guessing the market direction correctly for a single day by holding a 100X leveraged fund. While the advantage is undeniable, technically it is impossible to increase leverage much further margin requirements limit the amount of leverage possible. A commonly overlooked factor is that the chances of these funds going to zero over a short period of time increases as the leverage increases. Looking at the performance of FAZ/FAZ since its inception should make this pretty obvious — both these indexes show large negative returns over the few years since inception, indicating a strong possibility of both going to zero eventually.

We have nibbled a few times on FAS/FAZ per our previous tweets and blog posts. Following the March lows, we entered FAS for four days realizing a good return and followed it up with a few intra-day round trips that had a net effect of a small positive return. Our opinion is that these products are suitable for the following scenarios:

1. The benchmark index is at extremely overbought levels. Entering the bear-funds at such levels should prove beneficial over the short-term (a few days).
2. The benchmark index is at extremely oversold levels. Entering the bull-funds at such levels should prove beneficial over the short-term (a few days).
3. You anticipate a steady bull/bear market for the benchmark index. Entering the bull/bear funds during such market conditions should prove beneficial over the anticipated period (longer term).
4. Day trading when the benchmark index is extremely volatile, there is an opportunity to do roundtrips to realize small profits (intra-day).

Because of the leverage and associated risks, the above strategies should only be used with small portions of your overall portfolio. But, the risk-reward ratio is good assuming your strategies are sound and comfortable to work with.

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Last Updated: 10/2011 .