Direxion Daily S&P Biotech Bull and Bear 3X Stocks (NEW YORK:GOOD) provides investors with 3 times daily exposure to a broad diversified biotech index.
Backed ETFs like LABU are designed to track their underlying indices over a 1-day horizon. Longer holding periods will introduce significant tracking error from positive convexity and instability decay. Traders interested in the LABU ETF should first ensure that they fully understand the risks involved in leveraged ETFs by consulting FINRA AND SEC warnings.
Regardless of the risks involved, savvy traders can take advantage of LABU’s positive convexity as a swing trading tool. With financial conditions easing, there is a macro headwind behind biotech stocks that could help long-term investors. However, due to the increased volatility and drawdown risks, these leveraged ETFs are not recommended for beginners.
Summary of the Fund
Direxion Daily S&P Biotech Bull and Bear 3X Shares seeks daily returns that are 3 times the return of the S&P Biotechnology Select Industry Index (the “Index”). The fund achieves this leveraged return by holding index-based stocks and entering into total return swaps with major investment banks that reset nightly (Figure 1).
Leveraged ETFs are only designed to work on short time horizons
Investors considering the LABU ETF should be aware that leveraged ETFs only work as intended in short time frames. When we start looking beyond the 1-day horizon, volatility and convexity will start to introduce tracking error.
For example, if we started with $100 invested in LABU, if the index returns 5% on day 1, the position will grow to $115 (3 times 5% return). If the index returns 5% again on the second day, the position will increase to $132.25, more than three times the theoretical 2-day compound return of 10.25% or $130.75.
Conversely, if the index returns were -5% sequentially, then the initial investment would end up at $72.25, versus a triple loss of 9.75% or $70.75 compounded 2-day.
Finally, if the return experience is +5% followed by -5%, investors end up with $97.75, significantly less than three times the 2-day compound loss of 0.25% or $99.25. This ‘breakdown’ comes from volatility.
It is important to remember that leveraged ETFs have ‘positive convexity’ in the direction of his bet (ie the exposure increases as the bet wins), and he loses value from ‘disruption of volatility’.
Long leveraged ETFs as swing trading instruments
However, leveraged ETFs are not necessarily bad investments. They can be useful tools for sophisticated investors. Some swing traders like to use long leveraged ETFs like LABU precisely because of its positive convexity. For example, from the recent October 27 low of 4,991, the underlying index has risen 23.8% (Figure 2).
However, the LABU ETF, in contrast, has returned 78.7%, more than three times the underlying return of 23.8% (Figure 3). This difference is due to the positive convexity mentioned above.
In extreme circumstances when the underlying index rallies mostly in one direction over a long period of time, backed ETFs like LABU can deliver truly extraordinary returns.
From the COVID lows of 5,142 on March 18, 2020, the S&P Biotechnology Select Industry Index gained 163% to 13,513 on February 8, 2021. However, due to positive convexity and minimal pullbacks, the LABU ETF gained incredible upside (Fig,147% 4)!
The challenge, of course, is knowing when to enter these swing trades and when to take profits, as position sizes can grow very quickly and if profits aren’t taken along the way, they can disappear just as quickly with pullbacks because the pulls are magnified by the lever.
For example, even though the LABU ETF returned more than 11 times from March 2020 to February 2021, if investors had bought at the absolute lows of COVID from March 18, 2020 and held until today, they they would still have lost almost 70% of their capital (Figure 5).
Focus on developing a trading system before considering leverage
Before investors jump into backed ETFs in search of treasure, they need to have a solid stance trading system/strategy which may bring profits to the assets of the parties. Leverage from leveraged ETFs like LABU is a tool that only increases fundamental trading returns, whether positive or negative.
Easing financial conditions A push for biotechnology
Biotech companies are typically pre-revenue growth companies and are dependent on well-functioning capital markets and low risk appetites to finance their operations. When financial conditions tighten, equity financing becomes scarce and biotech stocks tend to suffer. We can see this relationship graphically by overlaying the SPDR S&P Biotech ETF (XBI) versus the Chicago Fed’s Index of National Financial Conditions. When financial conditions tightened as in 2008-9, 2011, 2015-2016, 2020 and most recently, biotech stocks typically struggle (Figure 6).
Recently, despite the Fed claiming to be tightening monetary policies to fight inflation, financial conditions have actually been gradually easing, with November 2023 readings back to early 2022 levels.
Easing financial conditions are rekindling animal spirits, as seen by the recent rally of cryptocurrencies in speculative stocks like biotech. As long as financial conditions remain loose, biotech stocks should have a tailwind.
In conclusion, long leveraged ETFs like LABU only deliver their stated leveraged returns over a 1-day horizon. Holding periods longer than 1-day will see significant tracking errors due to positive convexity and decaying volatility. Traders should be aware of these risks when considering leveraged ETFs.
Biotech stocks are benefiting in the short term from easing financial conditions. As long as these conditions persist, the LABU ETF should continue to have a tailwind.
Although I’m personally hesitant to trade leveraged ETFs like LABU, sophisticated agile traders can look to take advantage of the improved sense of risk by move trading LABU.