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The White Knuckle - Leveraged ETF Trading Strategy
At its core, The White Knuckle is a risk-parity strategy for three of the most volatile names in market: each a 3x leveraged ETF. A leveraged ETF is a fund that uses financial derivatives and debt to amplify the returns of an underlying index. -- Investopedia.com
For a 3x ETF, if the underlying index returns 1% on a given day, the fund would theoretically return 3%. Theoretical though, as management fees and transaction costs (which are high) diminish the full effects of leverage. The real rub? The 3:1 ratio works in the opposite direction as well. If the index drops 1%, the loss would then be 3%. |
Strategy Assets
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Just to be clear, these are primarily vehicles for the day-trading crowd. To buy one of these 3x funds with the intention of blindly holding on for a month is borderline nuts. So, what in the world am I doing buying three? Well, let's see how this works out.
Of the three, 3x leveraged ETFs in this portfolio, one customarily acts as a hedge to the other two, providing a modicum of balance to begin with. By the way, here are the funds in question:
The last one on the list, TMF, is basically long-term bonds on steroids. Over time, long-term bond funds have tended to have an inverse relationship with U.S. equities, of which SPXL and TQQQ represent in spades. But a word to the wise: in the stock market, as in the world at large, things are not always certain. Should all three funds decide to go down in unison, the results can be ugly. I try to mitigate some of that potential ugliness with risk-parity. What is Risk-Parity? Assets come with their own risk profile, which is influenced by the market and changes with time. A common example is stock and bonds; stocks are generally considered more risky than bonds. If an investor in these two assets wanted to keep the overall risk in his portfolio constant, all other things being equal, he or she would own more bonds than stocks. Then periodically reevaluate, and maybe add to stocks and subtract from bonds, or vice versa, all the while working to keep the overall risk constant. That's risk-parity; holding different assets and periodically changing the portion of each asset owned to keep the overall risk constant. On Wall Street, the higher the volatility, the riskier the asset. When the volatility of equities spike, risk-parity traders move to exchange some of their stock holdings for bonds. Likewise, when volatility rattles the bond market, these traders reverse course and exchange bonds for stocks. So, using volatility as our gauge, risk-parity overweights securities with lower-than-average volatility, and underweights securities with higher-than average volatility. For our purposes, this weighing mechanism is recalculated each month, and each fund is assigned a percentage that takes into account its relative volatility. For example, if volatility increases in the equity markets, implying an increased risk of a downturn, risk-parity would give more weight to the bond fund TMF and less to the equity funds SPXL and TQQQ. Finished? Not quite. In an effort to further reduce the risk inherent in owning these three funds, risk-parity notwithstanding, I added a "part-time" hedge that brings the following funds into play:
I say "part-time" hedge because it doesn't always kick in. I'll explain. |
The Mechanics
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Why all the gymnastics? Because I didn't want to commit three, 3x leveraged ETFs to 100% of the portfolio if I could hedge a portion of that with an alternative, especially when that alternative acts to reduce overall strategy volatility and max drawdown (maxDD).
So there it is. At any given time, The White Knuckle portfolio holds three, 3x leveraged ETFs of varying proportions that collectively make up either 100% of the portfolio, or 75-50% of the portfolio with the remainder in one or two "hedge" ETFs for further downside protection. Benchmark: SPY (the ETF that tracks the S&P 500 Index) is used as the benchmark by which we'll judge the performance of The White Knuckle.
And returns? The strategy delivered a total return of 3,716.6% vs. 254.4% for SPY over the same 10-year period.
Note: while the strategy fades higher-risk equity funds and increases allocation into the relative safety of bonds in the event of broad market downturns, nothing short of perpetually holding cash or cash ETFs will protect in the event of a flash crash or a sudden jolt to equity or bond markets. That said, the pain from most market downturns (i.e. recessions, bursting bubbles, market corrections) can be mitigated by a strategy that can move to relative safety within weeks. One final but very important note: The White Knuckle was not designed to occupy more than a portion of one's total investment portfolio. Maybe 5% - 10% - 15% or so, depending on one's risk tolerance. Despite the guardrails, this remains a relatively high risk strategy. |
What You Get
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Ready? |
The White Knuckle Strategy is $7.95 per month. Cancel at any time. Follow along and see how the strategy catches market moves to the upside, while protecting hard-earned portfolios against major downdrafts.
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