Volatility Drag, Leveraged ETFS, and Risk Tolerance

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Image source: http://the7circles.uk/sequencing-risk-pound-cost-ravaging/

You start with $100 and you lose 1% of your account, then you gain 1% of your account. Repeat this process many, many times, and you will have $0. 

If you’ve heard about leveraged ETFs, then you probably know about volatility drag and what it can do to the price of leveraged ETFS. An ETF, or exchange-traded fund, “is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund.” (Source: Investopedia.com).

A leveraged ETF, like TQQQ attempts to triple the returns of QQQ. The fund trades short term futures contracts which makes the fund three times more volatile than the regular QQQ ETF. If QQQ goes up by 1%, TQQQ should go up by 3%. And when QQQ goes down by 1%, TQQQ should go down by 3%.

You can probably already see the problem here. What happens if the QQQ goes down 10% first, then goes up 10%? QQQ would be down 1%, but TQQQ would be down much more since it dropped 30% then rose 30% afterwards.

Here’s what TQQQ would do based off what QQQ did above. Remember that the TQQQ roughly triples the returns of QQQ, whether it be up or down. When you start with $100 and lose 30%, you are down to $70. If you gain 30% now, you only get back to $91. Although the QQQ only lost 1%, the TQQQ lost 9%. Your first guess might be that TQQQ would have only lost 3%. Over time, this volatility drag ends up killing returns, which is why when people trade leveraged ETFS, they generally day trade it (buy and sell it within the same day) or hold it for very short periods of time.


 

Now let’s move on to risk tolerance.

In “Swing Trading for Dummies,” the author recommended risking no more than 7% of your total account value at any one time. The reason for this is to avoid volatility drag, and because probability exists, having a string of losses makes it harder to recover.

My take is that even at risking 10% of your account, it will only take 11% to recover, so I’m willing to risk 10% of my total account if everything goes to sh*t (all my stop losses are hit). Different people trade differently and have different risk tolerance, so do what is comfortable for you.

I’ve been inspired by a recent youtube video discussing how to get more comfortable with taking risk.

The main takeaway is this: You start out by asking yourself, “How much am I willing to lose?” You then gradually increase and decrease this amount until you feel comfortable. 

Let’s say you are willing to lose $100. When you actually lose $100, you say to yourself, “Ok, that was a lot more painful than I thought, I’m not willing to lose $100.” So all you do is drop that number down until you are comfortable. That number might be $90, $60, or $20, but it all depends on what you are comfortable with losing. Likewise, you can increase this dollar amount upwards to get comfortable with more risk.

Never risk more than you are willing to lose!

However, I found that when I think in terms of dollar amounts instead of percentages, I tend to be more risk averse, meaning I’m scared of taking risk.

If I lose 1% of my account and that is $350, I say to myself, “Well, I just lost like 350 chicken wings, it’s ok though, I just won’t eat lunch for a month.” In reality what happens after I realize how much money I just lost is my internal dialogue goes crazy: “OH GOD, THIS IS NOT OK — I then proceed to cry internally.” :^)

For me, it’s much easier to say, “Alright, I’ve lost 1% of my account, but this is no big deal, I will bounce back.” This results in no damage to my trading psychology, and I just go back to reviewing my trades and continue on with the grind.