The Leveraged ETF Safety Kit
06/27/2011 4:00 pm EST
Leveraged ETFs are gaining in popularity and offer several advantages to traders and investors, but there are also some critical risk factors to consider, as discussed here by ETF expert Deron Wagner.
My guest today is Deron Wagner, an ETF expert, and we’re talking about leveraged ETFs and inverse ETFs.
You may have traded regular ETFs in the past, but what are the risks and benefits of these particular ones? So, Deron, talk about, first of all, how these leveraged ETFs work.
Well, the way the leveraged ETFs work is when you buy an ETF that’s leveraged, it actually will move at a multiple of the underlying index.
So, for example, if you bought a leveraged ETF that follows the S&P SPDR, if the S&P 500 is up 1%, the leveraged ETF would be up 2%, and vice versa as well.
Generally, the leveraged ETFs—there are several different varieties—but generally, they move at a multiple of two times or three times the underlying index.
Now you hear of traders taking a lot more risk when they’re doing this, though. Is it something you recommend only intraday, or can I hold these overnight?
Well, I think there are a couple factors to consider.
One is you need to make sure your position size is positioned accordingly. So, we keep our risk the same with every trade we take in terms of the capital, the dollars risked. So if we’re using a leveraged ETF, then we have to reduce our share size to keep the risk in line.
The other thing to consider is that they can be used overnight, but there’s actually an underperformance that comes when you hold them longer.
Alright, and how about inverse ETFs; kind of the cousins of these leveraged ETFs?
Yeah, the same thing applies. Well, the inverse ETFs, the way they work is they actually move in the opposite direction of the index. So, if you’ve got the S&P 500, for example, up 1%, the inverse S&P 500 would be down 1%, and vice versa.
Normally, the inverse ETFs are what I find the most useful for people who have IRA accounts because retirement accounts are not marginable.
So, if you have a retirement account and you want to take a bearish position, give some exposure in a bear market, you can take an inverse ETF that will actually go up as the underlying index goes down.
Alright, and so why then—you mentioned this share size before and the leveraged ETFs with two times or three times—why not just triple or double your size on the regular ETF? Why trade these leveraged ones?
The leveraged ETFs, they’re ideal when people have smaller accounts. It gives you more “bang for the buck,” so to speak, but they are recommended mostly for short-term trading—not necessarily daytrading—but we don’t like to hold them more than a couple days.
They tend to underperform the index because there’s a daily rebalancing of the portfolio.