Pitfalls of Leveraged ETFs and How to Take Advantage of Them with Stock Options

Brokers are placing limitations on leveraged ETFs (Exchange Traded Funds) sales and in some cases stopping them completely. The Financial Industry Regulatory Authority (FINRA) has also weighed in, reminding brokers this past June to use caution when selling leveraged ETFs. What is the big deal with leveraged ETFs and why are their defenders and critics alike so passionate?

An exchange traded fund (ETF) is essentially a mutual fund that can be traded like a stock. An ETF represents a portfolio of stocks, often in a particular industry or mirroring a particular index, like the S&P 500. Unlike mutual funds, which are valued and traded once a day at the close of the trading day, ETFs are valued and traded throughout the day, just like a regular stock. They may even be sold short or bought on margin. So ETFs provide the diversity of a mutual fund without the sale restrictions of one. In addition, expense ratios are usually lower than the average mutual fund.

Leverage is a financial strategy in which assets are purchased with borrowed capital in order to increase potential gains. Leveraged ETFs, therefore, are ETFs in which a portion of the underlying assets are leveraged. Each ETF attempts to maintain a consistent amount of leverage, for example a 2:1 ratio. In this scenario, each dollar of invested capital is matched with another dollar of invested debt. If the underlying assets then return 1.5%, the fund returns, in theory, 3%.

So far, leveraged ETFs are looking like a good way to boost profits. One major problem is that losses are amplified as well. If underlying assets lose 1.5%, the fund (and thus its investors) will lose 3%. These losses can add up quickly.

The other major problem is that many individual investors do not fully understand how this investment vehicle works. They may believe that the above loss can be “fixed” simply by holding onto the leveraged ETF until it is profitable again. However, leveraged ETFs are not designed to be held for long periods; they amplify daily returns, not annual returns. Once you experience a loss in a leveraged ETF it becomes difficult to regain ground, because the base from which the fund grows has been reduced. Over time, it’s possible to lose money even if the underlying index gains.

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Leveraged ETFs are being vilified today because people who do not understand how they work have been burned. This is not the fault of the investment vehicle. It is the fault of the investor and his broker. Brokers have no excuse for not understanding this vehicle, and should ensure their clients are fully versed in the pros and cons before investing.

Leveraged ETFs are designed to be held for a few hours or a few days, not weeks or months, and certainly not years. Successful use of leveraged ETFs essentially involves timing the market. Most investors are notoriously bad at this activity. Still, many do it, and leveraged ETFs can be a useful tool for short-term traders who understand how to use them and who can afford the potential losses.

For long-term investors who just want a solid investment with solid returns, leveraged ETFs are a potential minefield. These investors are unlikely to have the stomach for the associated risk of leveraged ETFs, and brokerages are right to urge caution to inexperienced investors.

However, leveraged ETFs may be good investment vehicles when combined with stock options. Stock options enable traders to hedge investments risk associated with leveraged ETFs and potentially generate monthly income. A covered call investing strategy using a leveraged ETF can be entered by selling a call option against a purchased ETF. The amount the covered call investing position is in-the-money combined with the time value for the covered call can provided downside protection in the event the ETF drops in price.

The amount a covered call investing position is in-the-money is determined by the price difference between the price of the ETF and the strike price of the call option. For example an in-the-money covered call investing position was available for a leveraged financial ETF on 8/11/2009 with a potential return of 5.3% and downside protection of 10.4%. The time-frame for realizing the 5.3% potential return was only 39 days.

The price of the ETF was $5.30 and the price of the call option was $0.55. The month of expiration for the call option was September. The strike price of the call option was $5, so the position was $0.30 in-the-money, calculated as the strike price of the call option subtracted from the price of the ETF or $5.30-$5.00. The $0.30 represents a covered call investing position which is 5.7% in-the-money. The time-value for the position is calculated as the amount the position is in-the-money subtracted from the call options premium, $0.55-$0.30 or $0.25. The potential return of the position is calculated as the time value divided by the call option premium subtracted from the ETF’s price:

Potential return = time value / (price of ETF – call option premium)

= $0.25/($5.3-$-0.55)

= 5.3%

The downside protection is calculated as the price of the call option divided by the price of the ETF or $0.55/$5.30 which equals 10.4%. As long as the price of the ETF has not dropped more than 10.4% at expiration, the position will be profitable. Additionally, as long as the price of the ETF is greater than the call options strike price at expiration, the position will be fully profitable and return 5.3%.

This example illustrates how option investors can take advantage of stock options and leveraged ETFs to enter positions which have lucrative potential returns and also have nice downside protection. The downside protection provided by the covered call investing strategy can reduce some of the negative issues associated with leveraged ETFs and provide option investors a nice vehicle for potentially making monthly income.

As a side note, leveraged ETFs enable investors in covered calls the ability to generate monthly income even when the market is bearish, as there are inverse ETFs available which move contrary to the market.

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[tags] ETF, Exchange Traded Funds, Financial Industry Regulatory Authority, FINRA, brokers, leveraged ETFs, mutual fund, index, S&P 500, expense ratio, inverse ETFs [/tags]