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.

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