How to Use Leveraged ETFs to Your Advantage 11 comments
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Leveraged ETFs have gained a lot of popularity, and some scorn, in their relatively short history. They are popular because they allow retail investors to take aggressive positions without using margin or buying options. Inverse ETFs, whether they are leveraged or not, allow investors to short indices without a margin account. These funds are disliked because they do not accomplish what some might expect them to, which is to double the returns of the underlying index over an unspecified time period.
This is not what they were designed to do, as a visit to a website for a leveraged fund will quickly reveal. What they do is double (or in some cases now, triple) the return of the underlying index on a daily basis. The arithmetic behind this is simple.
Let‘s say the underlying index drops by 20% one day. To reach breakeven in the following day, it will have to rise 25%. The leveraged fund, however, will go down 40% on the first day and up 50% on the second day, leaving it at 90% of its original level. The numbers are unrealistic, but this is the kind of erosion you can expect over a long period of time.
These funds accomplish their stated goal of tracking daily movements pretty well, although not perfectly. I agree with David Fry, that people should familiarize themselves with what they invest in and stop the whining. These funds can be used to catch strong short term moves, but are much less suitable for long-term investing.
The S&P 500 vs. its leveraged and inverse leveraged funds
Let‘s look at how two of the most popular leveraged funds, SSO (2X leveraged S&P 500) and SDS (2X short S&P 500), have fared since July 13, 2006, when SDS first started trading. Since then, the S&P 500 is down 26%, SSO is down 58.1%, and SDS is down 3.4%. The fact that SDS is down over the entire period, while the underlying index is down more than a quarter underlines how hard it is to make money on long term positions in these funds. Over shorter periods, as witnessed by the performance of SDS from September 2008 – March 2009, leveraged funds can be spectacularly successful.
Selling bear call spreads on the leveraged funds
As we have seen, for leveraged funds to do well over long periods of time, they need a sustained trend in one direction. I, for one, do not have much faith in such a trend in the next couple of years. Instead, I am expecting range-bound trading with occasional sharp moves up and down.
For that reason, I think it is unlikely that either SSO or SDS is going to be much higher a half a year from now than it is currently. In an effort to capitalize on this belief, I intend to trade bear call spreads on both the SSO and SDS. That entails selling near the money calls and selling deep out of the money calls to limit the downside. As I am somewhat pessimistic about the market‘s outlook, I would sell calls deeper out of the money for SDS than for SSO. As an example, I will take a bear call spread with expiration on December 18, 2009. At the end of today, SSO is trading at 24.16:
Sell a call option with a strike price of $26 for $2.9 per share.
Buy a call option with a strike price of $35 for $0.65 per share.
The net debit for this trade is $2.25 per share and the breakeven is $28.9 on the SSO, 16.3% higher than it is currently. Maximum loss for the trade is (35-26) – 2.25 = $6.75 per share.
You can do this for both SSO and SDS and be almost certain that you will make a profit on one of the trades, have a decent chance of making a profit on both, and have a limited downside. If you think there is a high probability of a strong, sustained move in one direction in this time period, this is not the trade for you.
Disclosure: No position in the securities mentioned in this article.
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This article has 11 comments:
Buy a call option with a strike price of $35 for $0.65 per share.
The net debit for this trade is $2.25 per share and the breakeven is $28.9 on the SSO>
This should be net credit of $2.25. Break even at 28.25.
Is it not possible to short them?
Thanks
jsgilbert, it is possible to short the ETFs and it could make sense to short them for the long-term. I prefer the approach I outlined in the article as you can profit on the trades if the ETFs stay unchanged or even if they move against you, as long as the change is not too drastic. It also takes up less capacity in a margin account and has a specified end date.
First, both SSO and SDS have had large distributions. Have you taken them into account for your percentage gains or losses over time.
Second, you only gave half of the position. A bear call spread on SDS would be, in effect, a bull call spread. Is that what you want? Be specific. What is your "Bear call spread" position using SDS call options.
The half position you gave seems to me not worth the risk. A gain of $2.25 with the risk of a $6.75 loss.
The charts and return numbers I showed for SSO and SDS included the distributions. For someone who is selling calls on those ETFs, distributions are a good thing as they will limit the price increases of the funds, although the option prices should take this into account.
This article gave a conceptual trading idea and explained the reasoning behind it. I gave an example of the mechanics of the trade in the article for the sake of clarification, I was not trying to give a precise prescription for a trade. Specific expiration dates and strike prices would depend on each investor's expectations for overall market movements and risk tolerance and should take into account how the trade fits into a portfolio. Furthermore, a bear call spread on SDS is just that. "Bearish" in this context refers to the instrument in question, not your overall market sentiment. A careful reading of the article would show that writing calls on both SSO and SDS, in the expectation that neither would rise a lot over an extended time period is exactly what I want. If you want to pay me for investment advice, you may ask me to give more specific trading recommendations. Otherwise you will just have to take or leave what I write.
The last part of your comment makes no sense. You have to factor in the probability of each outcome and the maximum gain is obviously much more probable than the maximum loss. Using your logic, shorting stocks would never be a good idea since the most you can gain is 100% while the loss is unlimited. Also, if you were to write calls on both SSO and SDS, you would be getting roughly twice the premiums while keeping the maximum loss about the same, which changes the gain/loss ratio a lot. However, if you do not like the trade after a careful analysis of it, by all means do not make it.
"Let‘s say the underlying index drops by 20% one day. To reach breakeven in the following day, it will have to rise 25%. The leveraged fund, however, will go down 40% on the first day and up 50% on the second day, leaving it at 90% of its original level. The numbers are unrealistic, but this is the kind of erosion you can expect over a long period of time"
The math does not work the other way. To use a comparable example, let's say the index goes from 1 to 1.2 and the leveraged fund goes from 1 to 1.4. The index would have to drop 1/6th to go back to 1. The leveraged fund would in that instance drop by a third, which would leave it lower than it started (0.933).
Thanks, Gewis