ETFS

The leveraged ETF recommended in May has paid off handsomely after swooning in June. There will be a better time to get back in, writes MoneyShow.com senior editor Igor Greenwald.

A little over two months ago, I recommended the purchase of a leveraged exchange traded fund, the Direxion Daily Energy Bull 3X Shares (ERX).

The timing seemed right. A week earlier, high-flying crude prices had suffered a “flash crash,” caused, in retrospect, by the Obama Administration’s plans to sell crude from the Strategic Petroleum Reserve.

The slump in oil prices, compounded by broader market weakness, had driven ERX down 22% month-to-date—this after its value had quadrupled over a ten-month span.

The day I recommended ERX, major oil company chiefs were testifying on Capitol Hill in defense of tax breaks Democrats had targeted for cuts.

In short, the timing seemed right to jump aboard a secular rally experiencing an overdue correction.

As I wrote at the time, a lot of speculative froth had been skimmed off the oil trade (and off the general market bullishness that had prevailed in April). Concerns about the economic slowdown were already rife, and headlines about a “commodity bubble” about to pop were everywhere. 

I did caution that ERX could still move considerably lower. I warned of the “sizable” risk, and the possibility that crude could fall to $90 a barrel (it would actually dip into the high $80s later in the month, before recovering.)

But on the flip side, the case for higher energy-sector share prices was (and remains) strong, with oil-company valuations at multi-year lows, and demand from emerging markets compensating for the modest dip in domestic gasoline consumption.

The day the column ran, ERX opened at $70 and change, traded as low as $67.37, and ended at $71.34, its lowest close in two months.

And then I spent the next six weeks wondering:

  • Whether oil was headed back down to $60 again as a result of the dreaded double dip;
  • How I could have been so dumb;
  • When I should surrender and apologize.

I wrote multiple columns arguing that worries about another recession and bear market were overblown. I kept pointing to signs the tech stocks and commodities would bounce back.

But that ERX pick simply looked ill-timed. On June 27, with the broader market in danger of crashing through its 200-day moving average, ERX did the same, tagging a low of $60.77, down 15% since I’d recommended it.

And then, of course, the markets turned­—and so did energy stocks—and now ERX sits above $85. That’s a gain of 20% since May 12, good enough for me to declare victory and suggest that there will be better times to re-enter the trade.

I continue to believe that we’ll see significantly higher oil prices no later than a year from now. I continue to suspect that Exxon Mobil (XOM) is a steal at less than ten times estimated 2011 earnings, and just 5% more than it fetched on May 12.

But there’s no sense holding a leveraged bet, after the market has expended so much energy climbing out of the hole dug for it by the bears—many of those not being quite so bearish any more.

Besides the general feeling of relief, I exit the (strictly notional) trade with these hard-earned reminders about the nature of leveraged ETFs:

  • There’s no sense buying one—ever—unless you have a truly gargantuan risk tolerance, and are willing to absorb sudden and large losses.
  • There’s no sense buying one unless you believe that in the fundamentals of the trade over the long run—it can help you cope with the volatility inherent in trading with leverage.
  • Finally, leveraged long ETFs are more like call options than stocks, in the sense that their value is derived from the potential that the price of the underlying securities will move higher over time. But unlike options, leveraged ETFs don’t have an expiration date, and aren’t likely to lose all their value.

As I wrote in May, you do get to choose when to get out. I’m choosing today.

Tickers Mentioned: Tickers: ERX, XOM

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