FAZ 3x Financial Bear Fund Crushed

Apr 29, 2009: 11:36 AM CST

I wanted to call your attention to a major fallacy permeating the trading community regarding the 3x leveraged short (inverse) Financial fund FAZ.  Let’s compare FAZ and XLF (financial SPDR) and then challenge a common assuption that seems plausible at first, but upon simple inspection, the fallacy comes to light.

FAZ Daily Chart:

The FAZ has fallen 92% from its March 6th high of $115 (as of this writing, it trades now at $8.50 per share).  Keep in mind, this almost complete wealth destruction occurred in just over a month.  With such a dramatic move possible, it serves as a warning sign for newer traders to avoid these 3x funds… though often newer traders are the ones most drawn to the possibilities (as in, greater than 100% returns in a month which are also possible and have occurred).

Notice the volume surge that has occurred as FAZ plunged to new lows – volume reached over 300 million shares on trading days last week.  This is a result of lower prices (which mean we can buy more shares for the same money) and availability to more traders (with smaller accounts).

Be very warned if you’re tempted to think, “I’m going to buy at $8.00 because this fund is going to turn right around and go back to $110 in a month!”  You are devastatingly wrong – and I’ll show why.

Remember the FAZ is a three-times leveraged fund of the financial sector.  Let’s take a look at XLF, the AMEX Sector SPDR to put FAX’s 90% plunge in context.

XLF Daily Chart:

In the same time FAZ fell 90%, XLF rose 92% from its March 6th lows of $5.88 to its April 17th high of $11.33.  Is it any wonder a 3x leveraged inverse fund plunged so far?  There’s structural mechanics of these funds I don’t intend to discuss here (please read the prospectus and fund description for Direxion), but I want to challenge a common assumption that I heard discussed recently.

Let’s revisit the question “If I buy FAZ at $8.00, and the XLF falls, then FAZ will surge back to $110 if the XLF retests the $6.00 March lows.”

Categorically false.

These fund relationships are not linear but for argument’s sake, let’s assume they are.

XLF falls 50% (let’s make it easy) back to $6.00 per share.  This would imply a 150% increase (more than doubling) in the FAZ fund.  “Wonderful!” you say, and yes, that is an impressive return.  At the $8.00 per share level FAZ is trading now, that would take the fund up to $20.00 per share.

But it is NOT going to take the index back to $110 as some people think.

Assuming linear price logic (which again is not the case due to nuances in the leveraged funds), what would it take to get FAZ back to $110?

For FAZ to move (linearlly) from $8.00 to $110, that would be an 1,375% return.

To get a 1,375% return in FAZ would require a 450% drop in XLF.

Ok, I’m being facetious, but I wanted to challenge the logic that “If I buy FAZ  here, then it will shoot right back up to $110 next month and I’ll make a killing.”

The XLF would have to fall bit by bit, step by step, losing 10% in a day here, losing 20% in a day there, losing 5% in a day there on and on to bring the price of FAZ back to the $110 level.

It’s the same principle that if you lose 50% of your account, then you can’t get back to where you started by returning 50% on your reminaing capital – you’ll need a 100% return to get back to where you started.  If by chance you lose 90% of your trading account (say, moving from $100,000 to $10,000), then you would need to take your remaining $10,000 and trade it up 1,000% to get back to your original $100,000.

You very well might do it, but you’re not going to do it in a month or even a year.

The same percentage logic goes for those expecting FAZ to get back to $110 any time soon.

Sidenote – the same logic applies to those thinking DXO – double-long crude oil – is going to regain its mid-2008 price highs of $28 any time soon.  DXO currently trades around $2.00.  Using linear logic (again, only for simplicity), for DXO to move from $2.00 back to $28.00 would be a 1400% move which would imply a 700% rise in Crude Oil.

To drive the point home, if you think DXO is going to get back soon to $28.00, then Crude Oil – which trades at $50.00, is going to have to move up 700% which would take price to $350 per barrel.  Do you think that’s going to happen anytime soon?

Don’t fall victim to this “trader’s trap” in these leveraged funds!

Corey Rosenbloom, CMT
Afraid to Trade.com

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69 Comments

69 Responses to “FAZ 3x Financial Bear Fund Crushed”

  1. Corey Rosenbloom, CMT Says:

    Haha – love the moniker! Very creative.

    If that were to happen, one could short perhaps in a separate account.

  2. Corey Rosenbloom, CMT Says:

    Basque,

    No problem – from the data we have now, it seems the edge is shorting 3x and 2x funds and riding out the volatility as these funds – through percentage decay function – decline week by week.

  3. Corey Rosenbloom, CMT Says:

    Chris,

    Precisely – very well spoken.

    Now there are 2x commodity ETFs and 2x sector ETFs and more.

    It's going to happen to every single 2x and 3x fund unless changes are made.

  4. GonzoTrader Says:

    Thanks for the resp… a lot of good info here.

  5. Dave444 Says:

    Yeah, but its not 3X on FAZ or an exact percentage on any leveraged fund, because of the correlation to volatility – when the vix is low, you can expect 2.5%, when its high, it can be greater than 5% – which is what I was getting at below on another reason not to go long on them, unless you understand that. Day trading or a few days, great, but longer term – you have to read the VIX too. So for the argument of long term, just tracking the underlying index doesn't hold. RIFIN could start at anywhere on a chart, and FAZ could rise much faster provided the volatility is there.

  6. Dave444 Says:

    Yeah, but its not 3X on FAZ or an exact percentage on any leveraged fund, because of the correlation to volatility – when the vix is low, you can expect 2.5%, when its high, it can be greater than 5% – which is what I was getting at below on another reason not to go long on them, unless you understand that. Day trading or a few days, great, but longer term – you have to read the VIX too. So for the argument of long term, just tracking the underlying index doesn't hold. RIFIN could start at anywhere on a chart, and FAZ could rise much faster provided the volatility is there.

  7. The End of DXO - Double Leveraged Long Crude Oil | Afraid to Trade.com Blog Says:

    […] “FAZ 3x Financial Bear Fund Crushed (with discussion on DXO)” […]

  8. The End of DXO - Double Leveraged Long Crude Oil | Penny Stock Trading System Blog Says:

    […] “FAZ 3x Financial Bear Fund Crushed (with discussion on DXO)” […]

  9. bernard12 Says:

    These ETFs are all established to crush your portfolio. Even the normal energy ones such as USO and UNG screw you over with contango. The 2-3x etfs are good for day trading and for playing periods of high volatility if you “happen” to know when those will be. I prefer the financials and real estate. Also, it is interesting to see if the arrival of the new small cap etfs will increase volume in small caps in general.

  10. albot Says:

    Can anyone point me towards a liquid, no-leverage, inverse Chinese (Xinhua, Shanghai Comp, Hong Kong) equity ETF? Thanks

  11. david young Says:

    very well done

  12. david young Says:

    u paint a marvellous word picture
    hopefully others will get the message

  13. Nov1946 Says:

    didn't FAZ split 3 for 1 in March 10?

  14. Playmobil Says:

    As the rates go up and so as its previous values. This would be the last encounter don't you think?

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