TQQQ Trading: Two risks every leveraged ETF trader needs to know about

Back in 2017, we published an article titled Trading Leveraged ETFs for Max Profit, which explored what leveraged ETFs are, how they’re constructed, and strategies for trading them profitably.

Recently, a viewer commented on that lesson: “I still haven’t seen any good reasons not to hold leveraged ETFs long-term.” In this post, we’re going to answer that question and provide two concrete reasons with examples of why leveraged ETFs do not belong in a set-it-and-forget-it investment portfolio.

This lesson was intended and originally published as a video lesson so we recommend watching below:

 

Understanding Leveraged ETFs

If you’re not familiar with leveraged ETFs and how they work, we recommend reading our Part I Guide before continuing, but the brief refresher is that leveraged ETFs aim to deliver multiples of the performance of the underlying index they track. For instance, the TQQQ a very popular leveraged ETF aims to provide three times the daily return of the NASDAQ-100 (QQQ).

They achieve their objective through the use of derivatives such as futures, options, and swap agreements. While this leverage can amplify gains, it can also amplify losses and introduce some additional risk factors that every trader needs to be aware of which is the focus of this article.

 

The risk of diminishing returns trading leveraged ETFs

The first risk in holding leveraged ETFs is what we’re labeling the risk of diminishing returns and it’s caused by three factors:

  • Volatility decay
  • The fund’s cost of borrowing, rebalancing, and rolling
  • The fund’s expense ratio

Let’s circle back to what a leveraged ETF is and what they are intended for by reading directly from the TQQQ’s summary prospectus copied here:

 

The important call out is that the fund states: “for periods longer than a single day, returns will likely differ from the daily target.”

This means if you buy TQQQ at 9:30 AM market open and sell it at 3:59 PM, you can be pretty confident you’ll receive a return very close to a 3x performance relative to the QQQ. However, as soon as you decide to hold overnight and longer than intraday, you’re exposing yourself to the risk of diminishing returns.

At the 3:48 timestamp from our video lesson, we walk through multiple examples showcasing the performance of the TQQQ relative to the QQQ at various points in time over the last few years. In our first example, the QQQ achieved new all-time highs (June 2024) and is up approximately 18% from its 2021 peak and in contrast, the TQQQ is down 18% from its 2021 peak (June 2024).

This 36% delta shows the significant deviation that can occur over long periods of time. The underlying issue here is that the daily resetting mechanism of leveraged ETFs can lead to performance discrepancies over time, especially in volatile markets as was the case throughout 2022.

A broader example covered in the video using data from June 2014 to May 2024 reveals that while the QQQ had an annualized return of 18.27%, the TQQQ’s annualized return was 36.5%. This is closer to a 2x return, not the expected 3x. Over longer periods, this deviation is expected to become more pronounced, making TQQQ less appealing for long-term holding.

During periods of high market volatility, the impact of volatility decay becomes even more pronounced. That fact coupled with the costs of maintaining leverage, such as the interest on borrowed funds and transaction costs associated with rebalancing (internally within the fund, not your account), erodes the performance over time.

 

Risk of ruin: TQQQ case study

The second, more severe risk is the potential for total loss or risk of ruin. Leveraged ETFs use complex financial instruments like swaps to achieve their targets. According to the TQQQ’s prospectus, “The use of leverage increases the risk of a total loss of your investment.”

Here is another screenshot from the TQQQ Summary Prospectus:

As they state in the prospectus, a 33% decline in the QQQ at any point in the day could result in a complete loss for TQQQ holders. While this may seem unlikely, the risk is not zero and we know markets have a good track record of being unpredictable and good at testing the extremes.

Just a few years ago we saw an unprecedented event take place when the futures commodity contract for crude oil went negative! The financial crisis of 2008 and the sudden market drop in March 2020 due to the COVID-19 pandemic are stark reminders that market crashes can happen unexpectedly and leveraged products have blown up in the past like the formerly popular XIV ETF.

As you continue reading through the TQQQ prospectus you’ll also arrive at a section called Counterparty Risk. If the counterparty in a swap agreement fails to meet its obligations, the fund could suffer significant losses, explained in greater detail here:

Paying attention to a swift intraday decline that is objectively black and white to verify is one thing, but once you introduce layers of counterparty risk as a factor it introduces an additional opaque wrapper of risks that can be hard to decipher and quantify. To reiterate, we don’t consider the risk of ruin highly probable, but we do think it is possible. There exists some non-zero probability of a termination event happening and given a long enough time horizon, it’s all but guaranteed to trigger at some point in time, let’s just hope it won’t be in our lifetime.

 

Behavioral considerations trading leveraged ETFs

Beyond the technical and financial risks, there are behavioral considerations to keep in mind. Holding a leveraged ETF through a significant drawdown is emotionally taxing and can lead a trader into panic selling, deviating from their original strategy.

When faced with an 80% drawdown (TQQQ in 2022), many investors might feel compelled to sell their positions at the worst possible times, locking in significant losses. This emotional reaction can be detrimental to long-term financial goals. Understanding the psychological impact of such volatility is essential for anyone considering trading leveraged ETFs.

 

Trading leveraged ETFs: insights and recommendations

Despite all of the risk factors we’ve covered above, you might be surprised to learn that I still personally trade leveraged ETFs in my trading systems. At the time of publishing this video, TQQQ has been held as a portfolio position in our Galahad Trading System for 6 months and counting. You might ask yourself, but Evan, with all of those risks, why do you still trade them? Here’s my answer:

  • I am well informed of the risks and tradeoffs I am making by using leveraged ETFs
  • I position size my trades so I can sleep well at night and if necessary tolerate a worst-case scenario
  • I trade leveraged ETFs in pre-defined 100% rules-based systems to help me objectively manage every part of the trade
  • I have clear well-defined exit rules and I will not buy and hold these ETFs blindly

I like to think of leveraged ETFs as buying call/put option contracts. In options trading, a trader needs to get two dimensions correct, the direction and timing. Although leveraged ETFs don’t have a strike price or expiration date, they similarly benefit from precise timing. The better you can avoid chop, downtrends, and time going nowhere (volatility decay) the more successful your trades will be.

 

The good and bad of leveraged ETFs

Leveraged ETFs like TQQQ are very convenient products. They trade just like regular stock and there’s no need to navigate the complexities of futures or options markets in order to obtain leverage. However, it’s these nice and neat benefits wrapped up into a convenient package that traders need to think hard about. The risks of leveraged ETFs are not apparent unless you look under the hood, read the fund’s prospectus, and analyze the performance of the fund over various holding periods, as we’ve done here.

Leveraged ETFs can be a valuable tool for experienced traders with active trading strategies and thoughtful position sizing, however, we do not believe these ETFs are suitable for long-term set-it-and-forget-it investors.

There’s a phrase buy and hold investors often repeat and that is to maximize your “time in the market” rather than trying to “time the market”. With leveraged products, it’s the exact opposite, you will need to develop a strategy to time your trades in order to produce the optimal (desired) results.

I hope this follow-up Part II lesson helped shine some light on the risks beneath the surface. Good luck trading.

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Evan Medeiros

Evan is the founder of the Trade Risk. With 25 years of coding experience and a B.S. in computer science, Evan brings a systematic discipline to investing in the stock market.

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