By: David Goodboy - Street Authority
Exchange-traded funds (ETFs) have revolutionized the way investors approach the financial markets.
No longer are multiple accounts required to access the majority of indexes, currencies and commodities. Now, with a stock brokerage account, the self-directed investor can trade nearly every popular financial instrument with the click of a mouse.
Not only has access been democratized, but leverage has also undergone a revolution. ETFs that provide two and even three times leverage -- meaning they amplify the moves of an instrument or index by a given multiple, in either direction -- are available on a variety of financial instruments.
I'll never forget my first time using triple-leveraged ETFs. My technical research and fundamentals clearly indicated that the SP 500 index, the broad barometer of U.S. stocks, was overextended on the upside. A big drop was on its way, and it was going to happen soon.
Having just learned about the power of triple-leveraged ETFs to capture such a move, I was excited to have recently discovered the Direxion Daily SP 500 Bear 3X ETF (NYSE: SPXS).
I had a strong suspicion that stocks were going to dive sometime before Wednesday. So when the market opened Monday, I purchased the Direxion 3X Bear ETF to capture the move. My analysis was 100% correct.
As the market approached Monday's close, stocks started spiraling downward. The market behaved similarly on Tuesday with bearish news hitting the wire, causing the SP 500 to drop like a rock.
I was super excited, knowing that I was making triple the points on the upside since my triple-leveraged ETF was inverse, meaning it moved in the opposite way of the index. When I checked the position on Wednesday, I was fully confident of at least a triple in my account.
I couldn't believe my eyes.
My account was actually slightly lower than it was prior to the big drop and my purchase of the Direxion 3X Bear ETF.
What happened? There must be some kind of mistake, I thought.
Upon calling my broker, it was explained to me that the leveraged ETF was designed to track the daily movements of the index and not to be held for more than a single trading session. It was also noted that the triple-leveraged ETFs are rebalanced every night.
This rebalancing and the associated fees can actually make the ETF move in the opposite direction it is supposed to go. Had I sold at the end of the session when the SP 500 plunged, I would have been profitable.
But since I held onto the ETF for several days, I lost money, even with the correct analysis on direction. That was a difficult lesson to learn, so I started researching these volatile trading tools.
Leveraged ETFs, launched in 2006, are ETFs that provide more than 1-to-1 leverage to the underlying instrument or index. The mistake I made was based on the fact that the leverage is two or three times the daily movement of the underlying instrument or index -- and not two or three times the longer-term gains or losses.
In addition, ETFs sold as triple-leveraged are generally only actually 2 1/2 times leveraged. In other words, for every point the underlying index moves during the day, a leveraged ETF moves 2.5 times that amount.
Examples of popular double-leveraged ETFs include ProShares' UltraShort Dow 30 DXD ( NYSE: DXD), UltraShort QQQ (NYSE: QID), Ultra Gold (nYSE: UGL) and Ultra Euro (NYSE: ULE) and Rydex's SP500 (NYSE: RSU). Examples of triple-leveraged ETFs include Direxion's SP 500 Bull (USMF: DXSLX), Nasdaq 100 Bear (USMF: DXSSX) and Small Cap Bull (USMF: DXRLX).
Just how do these ETFs obtain leverage of this magnitude? In an effort to avoid complex mathematics, simply stated, it is done with a mixture of options, index futures and swaps to achieve the desired results.
Unfortunately, this financial witches' brew requires a daily rebalancing to maintain the desired leverage. This rebalancing results in extra management and interest costs, which will adversely affect profits if the ETF is held overnight.
Risks to Consider: Leveraged ETFs are powerful tools when used properly. Used improperly, they can spell disaster for your portfolio. Holding triple-leveraged ETFs overnight is just one dangerous aspect of leveraged ETFs. The other involves investors lacking money-management skills and biting off more than is prudent when trading these instruments. Remember, leverage will cut you if you are positioned opposite of the market's movement.
Action to Take -- It's critical to remember that leveraged ETFs are tools strictly for day trading. They can be vastly profitable if you are able to correctly forecast market direction on a day-to-day basis.
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