Skip to content
GetProfitable
Search
Dictionary

Volatility decay

The erosion of a daily-reset leveraged or inverse fund's value in a choppy market, caused by compounding percentage moves off a changing base.

The mechanism is that a percentage loss requires a larger percentage gain to recover, and leverage magnifies both legs. Reset the exposure daily and the asymmetry compounds. Decay grows with the square of volatility and with the leverage factor, so a 3x fund in a volatile index bleeds far faster than a 2x fund in a calm one.

This is not a fee or a flaw; it is arithmetic that follows from the daily objective. It is why the prospectus of every such fund warns against holding beyond a day.

Example: an index alternates plus 5% and minus 5% for 20 sessions and ends down 1.2%. A 2x fund alternating plus 10% and minus 10% ends down 4.9%, four times the index loss on an index that barely moved.

Related: leveraged-etf, inverse-etf, volatility, leverage, etf

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Margin and leverageA small deposit controlling a much larger position, and the point at which losses trigger a margin call.Position you controlnotional value $100,000your margin deposit: $5,000$100,000 / $5,000 = 20:1 leverageYour deposit absorbs every dollar of loss$5,000$2,500$0Equity leftMARGIN CALLequity has fallen to $2,5000%1%2%2.5%3%4%5%How far the price moves against you
Margin and leverage. A $5,000 deposit can control a $100,000 position, which is 20:1 leverage. Because the loss is measured on the full $100,000, a 2.5% move against you halves the deposit and brings a margin call, and a 5% move uses all of it.

Educational only, not advice. Spotted an error? Post in Site Feedback.