Using Options to Tame Leveraged ETFs

Much ink has been spilled on the pros and cons (mostly cons) of the new breed of leveraged ETFs that burst on the scene in the past year. They have quickly become a day trading favorite, with some of the ETFs turning over tens of millions of shares a day. The main knock on them is that they are just not suited to even medium term investors.In fact, due to their structure -- they calculate leverage for each day's move, and this gives them a downward bias overall -- they are not even suited to being held for a couple of weeks. Over any kind of a longer term, these products are toxic and will fleece investors of most of their money, no matter which way the market goes. For a more in depth treatment of the hazards of leveraged ETFs, see here.

So why do we want to mess with them? Well, while buying the ETFs is a sucker's game, the options on them can be quite interesting. Because they are leveraged, they reliably have insane levels of implied volatility baked into the options. We can even use their self destructive tendencies to our advantage.

One way to do this is to use calendar spreads. For example you can buy a deep in the money calendar spread on FAS, the 300% financial ETF. I like FAS because it has more liquid options, and it also has leaps available unlike many of the others. The fat premiums we are selling up front makes this position forgiving, and the fact that the strike price is in the money allows the ETF to drop quite a bit without hurting the position at all.

Here is the trade:

Buy 5 FAS Jan '11 70 calls

Sell 5 FAS Jan '10 calls

Net cost: $10.70 per combo ($5,350)

What's to like? Insane levels of daily volatility. This makes it easier to get our money back selling fat front month premiums. It also means that the ETF can move quite a bit without stranding the position too far from the strike.

Downward bias. These ETFs are going to single digits over time - it's baked right into the way they are structured. This means that any huge move to the upside does not have to concern us all that much. We know it's coming back down. And because the moves are only 3 times the daily change in the underlying, moves down become asymptotic. This means that any melt down will run into "support" and it will get harder and harder for it too fall all that much on a point basis. Again, this increases the odds that the ETF will stay near enough to our strike price for us to sell that sweet, sweet premium.

What could go wrong? Well, this thing is leveraged 300% and, even on a daily basis, this can lead to some very large moves if the market starts trending. Also, the guys who are issuing the ETF could go belly up or have regulatory problems.

Disclosure: Long FAS calls

Comments

[Augustus:]

Darned great idea. I'm going to look into this one.

Oct 21 01:34 AM

[rs53:]

"
Here is the trade:

Buy 5 FAS Jan '11 70 calls

Sell 5 FAS Jan '10 calls
"
Sell 5 FAS Jan '10 70 calls (same strike as Jan '11) right?

Oct 21 10:55 PM