The Downside Of Leveraged ETFs
Leveraged ETFs can add some excitement to a portfolio: bet right on underlying index, and you can earn double or triple the returns of that index. The downside of leveraged ETFs, though, is their potential downside. Consider one of the most widely-traded leveraged ETFs, the Direxion Daily Gold Miners Bull 3X Shares (NUGT): we're just about six weeks into 2013, and unhedged NUGT longs who bought the ETF at the beginning of the year are already down more than 29%, as of Tuesday's close (unhedged longs, that is, who didn't use stops. A quick search of Social Trade shows that the last Sloper who wrote about buying NUGT prudently used a stop order).
Too Expensive To Hedge Against A >20% Drop With Optimal Puts
As we noted in a recent post, hedging a security against a greater-than-20% drop can offer a reasonable compromise between limiting downside risk and lowering the cost of hedging. Unsurprisingly for such a volatile ETF (as of Tuesday, the 52-week high and low prices on NUGT were $26.69 and $7.62, respectively), its puts are expensive. On Tuesday, NUGT was too expensive to hedge against a greater-than-20% drop using optimal puts*. That's because the cost of hedging it against a greater-than-20% drop over the next several months was itself greater than 20% of position value.