What Is Compounding?
Compounding refers to the effect where daily returns are reinvested each day and accumulate over time. Rather than simply adding returns, it is a structure where gains build on top of previous gains.
If you earn 1% per day for 10 days:
Simple calculation: 1% x 10 = 10%
Actual compounding: 1.0110 - 1 = 10.46%
Positive Compounding (In a Trending Market)
When a trend persists, leveraged ETFs can generate returns exceeding a simple multiple. This is because each day's gains are added to the next day's investment principal.
If the underlying index rises +50% over a given period:
2x leveraged expected return: +100%
Actual 2x leveraged result: +120% or more possible
This is positive compounding. When an uptrend persists, the compounding effect amplifies leveraged returns even further.
Negative Compounding (In a Sideways Market) = Volatility Decay
When the market fluctuates up and down, leveraged ETFs suffer losses greater than expected. This is volatility decay.
| Type | +10% → -10% | Result |
|---|---|---|
| Underlying Index | 1.10 x 0.90 | 0.99 (-1%) |
| 2x Leveraged | 1.20 x 0.80 | 0.96 (-4%) |
| 3x Leveraged | 1.30 x 0.70 | 0.91 (-9%) |
Over the same period, the index lost -1%, while the 3x leveraged ETF lost -9%. The higher the multiple, the greater the impact of volatility decay.
So What Should You Do?
- Leveraged ETFs are short-term directional trading tools.
- Long-term holding carries the risk of volatility decay.
- Before investing, it is important to verify the leverage effect using historical data.