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Leveraged ETFs (LETFs) are known to lose value over time due to the "volatility decay" effect. What're the most common strategies for trading LETFs to take advantage of this volatility effect?

Also, are there trading strategies for LETF options? are there arbitrage opportunities among LETF options with different leverage ratios?

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  • $\begingroup$ They are likely to be banned soon, so why bother? ;-) $\endgroup$ – quant_dev Dec 19 '15 at 14:01
  • $\begingroup$ A warm welcome to Quant.SE! It is good practice in this community to upvote and accept answer if they were helpful - Thank you. $\endgroup$ – vonjd Dec 21 '15 at 8:30
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Quite a good article can be found here: http://seekingalpha.com/article/3140956-investing-in-leveraged-etfs-theory-and-practice

Just selling a pair of leveraged ETFs to harvest the "volatility decay" is comparable to a short straddle... highly skewed and therefore quite dangerous (from the article):

There are no free lunches in the market. The apparent high performance of strategies that engage systematically in shorting leveraged ETFs is an illusion, based on a failure to quantify the full costs of portfolio rebalancing.

The payoff from a short leveraged ETF pair strategy will be comparable to that of a short straddle position, with positive decay (Theta) and negative Gamma (exposure to market moves). Such a strategy will produce positive returns most of the time, punctuated by very large drawdowns.

The short Gamma exposure can be mitigated by continuously rebalancing the portfolio to maintain dollar neutrality. However, this will entail repeatedly buying ETFs as they trade up and selling them as they decline in value. The transaction costs and trading losses involved in continually buying high and selling low will eat up most, if not all, of the value of the decay in the ETF legs.

Concerning your idea of arbitrage the article gives some ideas on "relative value arbitrage" but although the author claims to be successful with it he gives no details, adding: "If that sounds rather complicated, I'm afraid it is", probably to attract some potential customers (but that is speculation).

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One standard strategy is to short both "bull" and "bear" ETFs (usually called "double short"). A bit naive heuristics is that if you're loosing money holding a long position due to volatility, you can at the same time make money holding short positions.

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