ETF Time Decay
27. Mar, 2009 
7 Comments
Many people do not realize that ETFs tracks certain indexes (for example UYG tracking financial indexes long) by reflecting the daily % gain or loss of the index. Therefore, the ETF’s gain compounds up or down depending on the behaviors of its index being tracked.
For example, if a fictional “ETF Long” fund tracked 2x (double) the performance of a fictional bank called “Bank of Illusion”, this is how ETF would behave.
So what does this mean? Well, the problem with ETFs is that they lose its value over a long period of time due to the volatility in the underlying index (or stock in my example) going up and down repeatedly.
Let me show you an example of how the different leveraged ETFs (1x, 2x, and 3x ETFs) lose the overall value long-term. And the “time decay” effect worsens with more leveraged ETFs – for example 3x ETF (FAZ) is worse than 2x ETF (SKF).
Click below to see enlarged image
Wow, you can see that in 10 days, the 3x ETFs lose the combined value by more than half. Horrible deal right? Well..the reality is that the index usually does not swing 10%+ every day. So in the real world, it looks more like this.
Click below to see enlarged image
As you can see, the ETF’s combined value did not lose so much value in a more stable market.
So to summarize, here are some of the key points to consider when getting into an ETF.
1) ETFs lose value over time
2) The more leveraged the ETF is, the worse its effect
3) The more volatile the index (or a stock), the worse the “time decay” effect
4) Don’t plan on holding ETFs long-term. Instead, play it when you want to ride the trend/momentum
5) Make sure you know what you’re doing before getting into a leveraged ETF
Good luck and happy trading!
Good article, nicely explained the concepts
Great explanation.
If you are a GREEK reader, of the four GREEKS, the THETA is the one that tells you of the time decay value left in your option.
Generally speaking, they ( options ) decay slowly and speed up toward the last two weeks of the month. They really start speeding up and reducing the premium in the last week and the fastest reduction of premium occurs on Thursday afternoon about 2 p.m. and thereafter practically goes to zero by Friday expiration. By noon on Friday, the options are effectively zero in premium value, but do not totally expire until the next day. If you trade LONG OPTIONS, the time decay, or THETA is very important, because in a slow moving mature bull trend, say of 3 points a day in the OEX, the TIME DECAY will shrink faster than the profit will rise, and you would LOSE MONEY by buying an option in a mature moving BULL TREND. Even though you are getting a positive move upward.
You can tell how volatile the BULL TREND is; by going to a VIX chart. Usually anything below VIX 20 will have time decay FASTER than the possible profit in an upward bull trend.
Credit spreads are the way to profit from TIME DECAY. You sell the option instead of buying it. Then collect the TIME DECAY as your profit.