Unlimited Danger Lurks In Leveraged Gold Miner ETFs

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April 6, 2017 9:41am NYSE:JNUG NYSE:NUGT

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From Sprott Money: Real gold is real money; however, in today’s financial system it is traded as a paper derivative. One day, we believe that gold will reclaim its throne at or near the center of the world monetary system.


Until that time, our strategy is to remain long precious metals in a nimble way, looking for any clues that the market may provide for near-term price direction.

Most precious metals investors know that gold and silver mining shares represent a leveraged play on the price of gold and silver. The indices that track the large gold miners, the HUI and GDX, have had a “beta” to gold of about 3:1. The GDX is an ETF that owns shares in a basket of gold and silver miners. If an investor would like even more gold leverage, then they can choose to invest in NUGT, which is an ETF that is designed to provide 3:1 daily returns in relation to GDX (and therefore roughly 9:1 to gold). The NUGT and its junior mining brother JNUG are triple leveraged financial derivatives of other financial derivatives. What could possibly go wrong?

March 15th, 2017, was a big day for the two most popular triple leveraged gold mining funds. NUGT closed 22% higher and JNUG closed 33% higher. One can see why these ETFs have many devoted followers; the appeal of a 33% daily gain can be difficult to turn down. But don’t believe the get-rich-quick siren song of these ETFs. Many a gold bug has had their sentiment shipwrecked by listening to it.

The primary reason to avoid NUGT and JNUG is the time decay inherent in any leveraged ETF. Below, we can see how the value of NUGT (in gold) over time slips below the value of GDX (in black), even when the value of GDX increases. There are a few reasons for this which we intend to cover in a follow up article. One quick application is this: it will almost always be better for an investor to purchase $3,000 of GDX rather than $1,000 of NUGT. By doing so, one would have the same reward potential, while assuming less risk. We may cover this in greater detail in a follow-up article.

We believe that most NUGT and JNUG investors understand the issue of time decay, and choose instead to day trade these ETFs. Presumably, these investors will purchase NUGT and JNUG when they believe that gold will rise on any given day or given week. Perhaps some investors have done well with this kind of market timing. Apart from market timing, we discuss below some cautions on day trading NUGT.

Day Trading NUGT

We would expect that as many as 30-35% of investors or traders have made money trading NUGT, and some have probably made a lot of money. Some traders are skilled at day trading, and have learned the disciplines to position size correctly, cut their losses soon, and ride out their winners. Others may have gotten lucky.

People make money day trading NUGT, and many blackjack players win at the casino. That doesn’t mean that either are a good idea from a risk-reward perspective. The odds for a good blackjack player are about 46%. We believe that the odds at successfully day trading NUGT is lower than this.


The House(s) Always Win

In a casino, there is only one house. In the day trading of NUGT, there are many “houses,” each of which usually gets a cut of the action. There are dark pools, High Frequency Trading (“HFT”) programs, market makers and others, all of whom have the (perfectly legal) ability to front-run, game and fleece the average investor.

Here is one example. Many, if not all, discount brokers sell stop-loss order information which ends up in the hands of dark pools and HFT programs . That is analogous to another player seeing your hand in a poker game. As a result, the “house” can see many hands, and they can adjust their algorithms to profit from that knowledge. With this market order omniscience, these intermediaries “know when to hold ’em, know when to fold ’em, know when to walk away,” and most importantly – they know when to run the stop loss orders.

Even if you don’t use stop loss orders, someone else does, and this creates a situation where the price of NUGT will move merely to take out stops, sometimes beyond any reasonable price expectations and correlations. Through this process, both volatility and trading anxiety will increase.

Beyond the stop running in NUGT alone, consider that these trading algorithms have the individual mining stock stop loss orders loaded, all of GDX stop loss information loaded, and all of DUST’s stop loss orders loaded as well. The algorithms can then move at the speed of light to optimize profits among and between all of these connected securities. Most likely, the algorithms will profit the most when these securities diverge irrationally (such as when gold rises and the price of NUGT declines, or when GDX goes down and NUGT goes up). We imagine that many day traders watch the price of GLD and GDX while trading NUGT and say to themselves, “It isn’t supposed to move that way!”

The “prop trading” desk at almost every investment bank makes money every single trading day. Where do you think those profits come from? In day trading of NUGT, there is too many ways for the house to win. And most likely, died-in-the-wool gold bugs are their favorite customers. If you called and asked, they would likely send you free drinks each day to play.

Conclusion

We are long-term bulls for precious metals. When precious metals are finally set free from their paper chains, we will likely see giant leaps in value. The mining shares – being leveraged to the price of gold – will see even greater jumps in value. When that day comes, being long JNUG and NUGT might be a good thing (assuming of course that the gold miner’s derivatives market itself doesn’t implode in the process).

We imagine that many a gold bug has had their sentiment shipwrecked by following the get-rich-quick siren song of NUGT and JNUG. Those of us who believe in sound money would prefer that you stay the course and not get sidetracked. Don’t listen to the siren song of NUGT and JNUG. If you want general gold miner exposure with the potential upside of NUGT, it is better for you to purchase $3,000 of GDX rather than $1,000 of NUGT. Better yet, purchase real gold and real silver in a vault of your choice.

The Junior Gold Miners Bull & Bear 3X ETF (NYSE:JNUG) fell $0.09 (-1.29%) in premarket trading Thursday. Year-to-date, JNUG has gained 22.76%, versus a 5.18% rise in the benchmark S&P 500 index during the same period.

JNUG currently has an ETF Daily News SMART Grade of F (Strong Sell), and is ranked #16 of 22 ETFs in the Leveraged Commodities ETFs category.

Meanwhile, The Direxion Daily Gold Miners Index Bull ETF (NYSE:NUGT) fell $0.14 (-1.43%) in premarket trading Thursday. Year-to-date, NUGT has gained 26.57%, versus a 5.18% rise in the benchmark S&P 500 index during the same period.

NUGT currently has an ETF Daily News SMART Grade of D (Sell), and is ranked #8 of 22 ETFs in the Leveraged Commodities ETFs category.


This article is brought to you courtesy of Sprott Money.


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