Rinse, Wash, Repeat: A Way to Survive Leveraged ETFs' Gyrations

Jim Trippon  |

I am an unashamed defender of leveraged ETFs and with every criticism of these products, I grow more convinced that I'm right. Maybe I feel that way because Criticism B of leveraged ETFs will almost certainly be no different than Criticism A and the reality Criticisms A through Z will all basically be the same.

I digress. I'd prefer to spend our time looking at profitable ways to engage leveraged and inverse ETFs within your portfolio. One thing that I always tell folks about leveraged and inverse ETFs is that under NO circumstances should these instruments become long-term holdings in your portfolio. My catch phrase if you will is “Don't treat leveraged ETFs the way Warren Buffett treats Coca-Cola and hold them forever.”

When I say that, I hope investors listen. Realizing that some don't and that anyone can find themselves in a bind rather quickly with leveraged ETFs, I recommend writing covered calls on these funds as not only your personal bailout plan, but a profit plan as well. Let me put it to you like this: One of the primary knocks against leveraged ETFs is how volatile they are and that as a result of that volatility, retail investors should not be involved with these funds.

The other side of that coin is the more volatile a security, if it's optionable, the options premiums tend to be quite attractive. Put it this way: Volatile ETF + high options premiums = Great ETF for covered calls.

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I'll illustrate using a hypothetical situation with a real life ETF and real life options premiums. Let's say you were fortunate to have bought the Direxion Daily Financial Bear 3X Shares (FAZ) on Monday Oct. 31 when the ETF was trading just below $40. Noting that FAZ is extremely volatile and can generate double-digit one-day moves quite easily, you also sold the November 49 calls for $1.30. On Tuesday, FAZ jumped $5.22 to $45. Great news for your long position, not great for those calls because they more than doubled. But hold on for a second.

Those November 49 calls expire on Nov. 19 and the ideal scenario here would be for FAZ to expire somewhere over your entry point into the ETF, but below $49 so the calls expire worthless and you've made money two ways. That's what happens in a perfect world, but we all know Mr. Market has his own plan and it doesn't always jibe with ours.

Let's say you bought FAZ in mid-October around $51 thinking financials were in for trouble. Now you're out $600 per 100 shares and you've said to yourself, I want out, but want to take a smaller loss. Sell the November 47 calls for $4.05 per contract. This shaves your $600 loss down to just $195 (100 x $4.05 = $405).

Or you can opt to get really adventurous. I'll show you how. Let's say you're convinced the worst is over for financials and the sector is going to rally from now through mid-January, but you want to hold FAZ as a hedge on some individual bank stocks you own. It's a stretch, but anything is possible. You could sell the FAZ January 2012 49 calls for $8.35 per contract. That's $835 per contract in income! You're not going to find those types of premiums with anything but leveraged ETFs.

For further information on the ETF markets, you may visit www.etfprofitreport.com or join us at www.globalprofitsalert.com for our daily market commentary. I will look forward to bringing my exclusive insight to you next week.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.


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