Reducing Risk on Leveraged ETFs With Options

08/13/2013 8:00 am EST


Leveraged ETFs have become very popular among active traders looking to increase their exposure to a given index without buying on margin, writes Justin Kuepperof

While the SEC has warned of the risk of leveraged ETFs on multiple occasions, many traders continue to utilize these ETFs without taking into account all of the associated risks. For example, the daily compounding they employ means that a 10-point move down one day and a 10-point move up the next may actually produce a loss.

In this article, we’ll take a look at how to reduce the risks associated with leveraged ETFs by using stock options.

Why Are Leveraged ETFs So Scary?
Leveraged ETFs are exchange-traded funds that use derivatives and debt to amplify the returns of an underlying benchmark. For instance, the ProShares Ultra S&P 500 (SSO) utilizes swap agreements and forward contracts to produce twice the daily performance of the popular S&P 500 benchmark index. While they provide traders with useful leverage to capitalize on short-term movements, the same leverage could make them dangerous in the wrong hands.

There are two primary factors that make leveraged ETFs dangerous for inexperienced and uneducated traders—compounding effects and reset periods. Most leveraged ETFs are reset on a daily basis, which means that exposure to the index is reset at the end of every trading day and returns can be compounded in the wrong direction. For example, in a seesaw market an underlying index can post a modest gain with the associated leveraged ETF posting big losses.

Options on Leveraged ETFs: A Recipe For Disaster?
Given the many risks associated with leveraged ETFs, trading their options may be seen as a recipe for disaster, especially given that options themselves are often misused by inexperienced traders and investors. In some cases, however, options can actually help tame the volatility seen in leveraged ETFs in order to make them less risky. And in other cases, they can be used in order to achieve or control more specific outcomes.

For example, traders looking to short a leveraged ETF must not only find enough shares to short sell but also scrape together a significant margin requirement. An easier alternative may be to purchase deep in-the-money put options that don’t require margin or hard-to-borrow shares in order to capitalize on the same downside. Perhaps even more importantly, the most that trader could lose is the premium paid, which could significantly de-risk the position.

Options Strategies for Leveraged ETF Traders
Covered calls and protective puts are the two simplest strategies that can help reduce risk by either generating an immediate income that offsets costs or securing the right to sell at a certain price in order to establish a price floor for the position. Traders can enter into these positions by either writing a call option or buying a put option against an existing position, thereby limiting the position’s total profit and/or loss potential.

Spread strategies can be utilized to even more tightly control risk by setting an upper and lower limit on the price action. For example, a trader could write one call option at a higher strike price and buy another call option at a lower strike price, both with the same expiration date, to create a bull call spread. The written call helps pay for the purchased call’s upfront costs, while the two strike prices provide a ceiling for maximum profit and maximum loss.

Traders can also take advantage of the differences between leveraged ETFs and traditional ETFs focused on the same underlying index. For instance, traders concerned about their leveraged ETF holdings diverging from the index’s performance can purchase call options on the traditional ETF to hedge some of their exposure. Of course, call options on these traditional ETFs could also be used to generate leverage without the use of leveraged ETFs altogether.

The Bottom Line
Leveraged ETFs are a great tool for active traders seeking leveraged exposure to an underlying index, but daily resets and compounding makes them risky for the inexperienced. Adding options to the mix may seem like only adding another layer of complexity, but in reality, they can be used to better control risks and outcomes. Active traders should consider common equity option strategies when developing their leveraged ETF strategies.

By Justin Kuepper, Contributor,

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