One Way To Profit With Leveraged ETFs

Includes: FAS, FAZ, TNA, TZA
by: Ketan Desai

Many writers at Seeking Alpha have detailed the perils of leveraged ETFs such as TZA, TNA, FAS and FAZ. However, they can be a great way of leverage if an investor is convinced of the direction of the market.

Take the case of two opposing ETFs, TZA and TNZ. TNA is 3x bullish on Russell 2000, while TZA is 3 x bearish on the same. If an investor is a bear, TZA is a great play. Similarly, if an investor is a bull, TNA is a great play. However, they should not be held for long periods of time as the value decays with time since they are compounded daily. Another problem with either is that they raise the obvious problem of timing the market - buying and selling these volatile and leveraged ETFs carries the risk of sharp and sudden losses if the market goes against the investor.

One way an investor can avoid the problem of timing the market while taking advantage of the decay in the value of these ETFs is by shorting equal shares of TNA and TZA. To further investigate, let us take the long side of the equation.

Let us say an investor bought TZA on Oct. 6, 2010, at $73.83. TNA on that day was $49.31. If the investor bought equal value of each shares, lets say $100,000 worth each, that investor would have bought 1354.63 shares of TZA and 2027.98 shares of TNA. As of Oct. 5, 2011, TZA was worth $49. 59 and TNA was worth $33.05. Value of TZA = 1354.63 shares x $49.59/share was $67,176.102 and TNA = 2027.98 shares x $33.03/share was $66,984.179. The portfolio value would be worth $134.160.28, while the starting value was $200,000. This would result in a loss of $65, 839.72, or approximately 32%.

In the above, I assumed the investor had bought equal dollar value of TZA and TNA. But even if one did the calculation for equal shares, the investor still loses money. Lets say the investor bought 1,000 shares of TZA on Oct 6, 2010 for $73,830 and 1,000 shares of TNA for $49,310 for a total investment of $123,140. The value of the portfolio as of last night would be TZA $49,590 and TNA $33,030 for a total of $82,620. Thus, the investor would have a loss of $123,140 – 82,620 = $40,520, or approximately 32%.

As seen in this example, being long both is not profitable. But being short both is. In the above example, an investor would have made a 32% profit if s/he were to short equal shares of TNA and TZA for a year.

One can, in theory, also use options to trade this strategy. But options for leveraged ETFs are very expensive - for example, Jan 13 TZA puts with strike price of $50 are worth an incredible $25. For this reason, I don't think buying puts on TNA and TZA will pay off for this paired trade.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in TZA, TNA over the next 72 hours.