Market Not Risky Enough for You? Try These Two New Triple-Levered ETFs

That’s right, I’m tired of all the stability, certainty, and guaranteed returns in the stock market lately.

Or so seems to be the thought process behind Direxion Funds’ introduction of a couple of brand-new ETFs into the market yesterday.

One fund is a bullish fund (BGU) and the other is bearish (BGZ), each looking to replicate the gains or losses of the Russell 1000 index… except at three times leverage. In other words, 300% of the gains or losses that the Russell 1000 enjoys or suffers can be yours for the price of three little letters.

Some investors are horrified by this idea – that the already huge market swings we’ve recently experienced could be amplified with derivative securities such as these – and will shy away from them because their knuckles are white enough as it is.

Who believes this country needs more leverage of any kind?!

I do.

Not only am I not horrified, I am excited beyond belief for quite a few reasons.

An impatient trader’s dream

The best friend of a trader, particularly intraday, is volatility. Large price swings allow more opportunity for traders to move in and out of stocks, currencies, commodities, or other cookie jars they might have their hands in.

Some traders prefer to trade index funds that replicate returns of either the broad market or at least sectors of the broad market. The reason for this is that although we welcome volatility, the surprises that are associated with individual stocks are not often viewed with kind eyes.

There are benefits and drawbacks to trading broad market indices. For example, there is a reduction in company risk, which as of late tends to be more dangerous than market risk. In other words, if a company reports dismal earnings, layoffs, or shocks investors with a few “mistakes” in its accounting measures, that particular stock is sent to the gallows, whereas the overall market may only be minimally affected. True, market risk still exists, but comparatively it can be much more devastating (percentage-wise) for a company to come out with poor news than the entire market to come out with a surprise.

The problem with trading broad market indices in a small time frame is that traders are exchanging company risk for less volatility – thus less chance for price fluctuation and higher returns.

With these newly introduced funds, traders can avoid the risk associated with owning an individual company for any length of time, but receive the large price fluctuations normally only associated with individual stocks… or even more so.

Somewhere between owning a stock and an option

The typical investor is comfortable with the familiarity of owning a stock – in other words, a long position. Shorting stock or purchasing options are strategies used by more seasoned and (debatably) knowledgeable investors who are willing and able to take on greater risk in hopes of greater returns.

Shorting a stock, technically, has unlimited downside risk. When a stock is purchased, it can only go to zero. When a stock is sold short, it could – probably not, but could – go up for an indefinite period of time.

Options are a common speculation and hedging tool used to increase or insure their returns. Options are inherently risky, not only because they amplify profits or losses, but also because there is a huge premium involved with the time component – it’s part of what you’re paying for with options. A related fact you may or may not know: if you could, somehow without transaction costs, sell every option on a stock (puts and calls), you would always make money at expiration.

The benefit to these new ETFs in terms of risk is that investors who are looking to amplify their returns can take advantage of moves up or down in the market by going long one security. There is no “infinite risk” of shorting a stock, and there is no time value depreciation as we would see in options – not to mention decreased transaction costs.

The turnaround and beyond

Direxion (who must have stayed up all night thinking of that name) picked a perfect time to unleash these funds. Intraday volatility aside, what would investors say to the notion of earning their capital back three times as quickly as they lost it?

Those people who have a belief that we are close to a bottom in the market (I am one of those people) would be looking to buy. Why not buy something that tracks the same securities as an index fund that will increase in value at three times the rate of that index fund? If you’re confident about the direction, there isn’t much to be said against using one of these two ETFs.

I fully expect these two securities to trade more and more actively over the next few months and years, perhaps not as much as the S&P Spyders, but daily trading in the tens of millions. In addition, as a trader I am excited for the future. After the dust settles, after the extreme volatility has gone and most days end with only small gains or losses across the market, there will still be vehicles that can amplify the market volatility enough to trade into profits.

Disclosure: No positions.

Comments

[Xyrus:]

These and other levered products do not return 300% of the index. They return 300% of the daily percentage increase or decrease. In a volatile market, you better be sure you know the difference, as your returns may not be anything close to what you expect.

Read the prospectus and then do the math on a couple of scenarios. You're return degrades over time in a volatile market. These are really better to hold in a trending market, unles you're going to day or swing trade.

~X~

2008 Nov 09 08:23 PM

[Prudent Man...:]

I can see why Vegas is having trouble.

One thing I learned as a depression baby, you can't be put in bankruptcy unless you have debt. Three to one debt to equity is certainly fun but remember there is negative leverage as well as positive leverage. I even heard that they might be teaching the risks of negative leverage at Harvard, MIT, Wharton, Yale and Stanford.

When students are taught that they can walk on water with and elite degree, a taste of reality should be in curriculum before they go into investment banking and crush pension fund investments.

2008 Nov 10 12:01 PM

[Fatty:]

Beware the large expense ratios of these funds. They are definitely no good for long term holdings as the day-to-day volatility will dampen the returns over time.

Depending on the index return you are targeting, it may be beneficial to use futures to achieve the same leverage ratio (if a liquid future is available).

2008 Nov 17 11:14 PM