The Risk of Leveraged ETFs Explained in Simple Terms (NYSE:SSO),(NYSE:DDM),(NYSE:RSU),(NYSE:SDS)

The following is probably the best explanation of the risk with leveraged exchange traded funds (ETFs).  It holds true for leveraged long and short ETFs such as ProShares Ultra S&P500 (ETF) (NYSE:SSO), ProShares Ultra Dow30 (ETF) (NYSE:DDM), Rydex 2x S&P 500 (ETF) (NYSE:RSU). and ProShares UltraShort S&P500 (ETF) (NYSE:SDS).  Now don’t get me wrong, I really like the leveraged ETFs and have used SSO to do my bidding, but one must understand the nuances of the leveraged ETFs and how they perform.

The explanation comes to us today from Donald Luskin at SmartMoney.  His post over at MSN provides a good example of how the leveraged ETF can work over the longer term and impact your bottom line.  Please do keep in mind that his example is an extreme because it shows the baseline index makes a 20% gain in one day and then gives it all back (-20%) the next day.  That is quite a swing, but you will at least get the idea because the he explains it well.  Like to hear it? Here it goes…

Luskin: Let's say you pay $100 for an LETF that tracks an index and that the index is at 100. If the index goes up 20% the first day, it will be at 120. Your LETF promises you twice the 20% return -- that's 40% -- so your $100 grows to $140. So far, very good. Now suppose the next day the index falls back to 100. That's a drop of 16.7% (after rounding), so the LETF has to give you twice that -- a loss of 33.3%. Does that bring your LETF back to $100 where you bought it?

You might think it would. Since the index is back to square one, why shouldn't your LETF be back there, too?

Simple. Your LETF was worth $140, and 33.3% of that is $46.62. So your LETF is now worth $93.38, not $100. You see what happened? Over each of the two single days, the LETF did exactly what was promised -- exactly twice the daily return of the index.

But over both days put together, it didn't do that at all. Over two days, the index had a zero return. So you'd think the LETF should give you twice zero, which is still zero. But, no, it gives you a net loss of 6.6%

Read Luskin’s whole article here.