There will times in the marketplace that investors may decide to take advantage of cheap protection to protect their investments. Protection can take form in ways and some ways of protecting a position include selling an upside call against shares, buying a put or using a leveraged ETF (just to name a few) to balance out risk in an investor's portfolio.
Investors may also want to seek protection when certain economic indicators are approaching and investors feel that these economic indicators may disappoint investors. Some of these economic indicators include U.S. Job data, FOMC meetings, and Consumer Confidence to name a few. If investors want to seek broader protection against the market rather than take protection on their individual holdings, then leveraged ETFs can provide a form of protection if used properly.
Leveraged ETFs are exchange traded funds that try to magnify the return using leveraged money and are leveraged at 2:1 (double the return/loss) or 3:1 (triple the return/loss). When considering using leveraged ETFs there are advantages and disadvantages and these should be taken into consideration prior to making a trade.
1) Exposure to a particular sector or the entire market without focusing on individual companies.
2) Gains are multiplied since the ETF is leveraged, but so are losses.
3) Good for short-term trading or if market continues in one direction for a period of time.
4) Can perform well in volatile markets depending on what side of the trade you are on.
1) Leveraged ETFs should be used for short term trading and not for a long term investment.
2) Ability to be able to time the market.
3) Losses can accumulate quickly due to leverage.
4) In a sideways/flat market leveraged ETFs generally won't perform well.
5) Investors will not always realize to full 2x/3x or opposite due to rebalancing every day.
6) Trades need to be carefully monitored and can be frustrating at times.
When thinking about using leveraged ETFs or other forms of portfolio protection there are a number of factors that newer investors should also consider:
Price: Investors will need to pay close attention when wanting to make a trade to achieve a favorable bid/ask price. Generally investors will want a bid/ask price no greater than 5, since a wider bid/ask price will be unfavorable. Sometimes the bid/ask prices can stretch out and if you buy at the ask price, it could be tough to sell at the bid price (for profit) since this is a lot lower than the ask price.
Don't Buy Blindly: Just because investors want the opportunity to buy protection doesn't mean investors should just jump right into a leveraged ETF or buying a put option on the SPDR S&P 500 ETF (SPY). Sometimes with a bullish portfolio it can be tempting to take out protection if it's cheap. But, investors should be able to provide a list of reasons for wanting to pull out the protection card along with buying at a price that investors feel comfortable with in case the protection trade doesn't work out.
Practice using a hypothetical portfolio around certain key events: You can never go wrong using a hypothetical portfolio and by using a hypothetical portfolio newer investors can get a taste of how leveraged ETFs work without losing any capital.
Take profits and move on: In my opinion, leveraged ETFs are meant as a hedge for your portfolio and I would not considering using these as investments, but rather a trade.
Patience: When deciding to protect your portfolio sometimes using leveraged ETFs may not go your way. Newer investors should only spend money for protection that they are willing to lose and not gamble on economic news or weather the S&P 500 or Dow is going to have a bad day. When considering using leveraged ETFs or other forms of protection, investors should always consider using a blend of technical analysis when making their decisions.
Relative Strength, Full Scholastic and Bollinger Bands are a few of the many technical indicators that I use when trading and patience can also make or break an investor's trade. For example, on March 16, 2012 I wrote an article titled, "Time To Consider Puts On The S&P 500 index" and while the trade didn't work out at first, about nine days later the SPY went from around 140 to 136 in about a week and this nice trend downward would have brought investors some nice gains in the five day sell off.
For investors that want protection against a drop in the S&P 500 or Dow Jones Industrial average, here are two leveraged ETFs to consider:
1) ProShares Ultra Short S&P 500 (SDS): The SDS seeks daily investment results that correspond to twice the inverse (-2%) of the daily performance of the index. Basically, a 1% drop in the S&P 500 means up to a 2% gain in the SDS. For less amplification investors could also look at the ProShares Short S&P 500 (SH) which has a (-1%) inverse.
2) ProShares Short Dow 30 (DOG): The DOG allows investors to short the entire Dow Jones Industrial Average and could be considered as a hedge if Investors have a large weighting of their portfolios in the Dow Jones Industrials. If the Dow Jones Industrial average falls 1% this fund could gain 1%
Both of these ETFs also have options trading available if investors want to risk less to make more. Generally, I will use these ETF's if I believe the S&P 500 and the Dow Jones Industrial average are getting near overbought levels and I am looking for alternative ways for portfolio protection.
Currently, if the SPY makes another run for the 142 level, I will consider SPY puts or the SDS calls and if the Dow Jones Industrial average gets to around 13,200 to 13,300, I would also consider taking a look for some cheap protection using the DOG.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.