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Short and Leveraged ETFs - 3 Things You Must Know Before Trading
By, Simon Maierhofer
Friday July 06, 2012
Short and leveraged ETFs account for more than half the trading volume of some popular indexes, like the Russell 2000. But like driving on the autobahn, leveraged ETFs come with risks that need to be managed.

About 168 million shares of the SPDR S&P 500 ETF (SPY) exchange hands every day. SPY is the largest and most actively traded ETF in the world.

More than 35 million shares of short and/or leveraged S&P 500 ETFs are traded every day. This includes the UltraShort S&P 500 ProShares (SDS) and Ultra S&P 500 ProShares (SSO).

The iShares Russell 2000 Index ETF (IWM) has a 3-month average trading volume of 54 million. The two triple leveraged Russell 2000 ETFs – Direxion Daily Small Cap Bear 3x Shares (TZA) and Direxion Daily Small Cap Bull 3x Shares (TNA) – have a trading volume of 37 million shares.

Obviously short and leveraged ETFs resonate with investors, but there are risks everyone needs to be aware of before hitting the “buy” or “sell” button.

The risk can be split in two categories:

1) Replication tracking error

2) Leverage tracking error

Replication Tracking Error

Short (leveraged) ETFs attempt to deliver 1x, 2x or 3x the inverse performance of the underlying index. To deliver inverse performance, ETF providers use instruments like swap agreements, futures and options.

Unlike the S&P 500 SPDR ETF (SPY), which completely replicates the underlying index by owning all components, short (leveraged) ETFs can only attempt to duplicate the daily performance of the underlying index by using alternate financial instruments.

To illustrate, imagine describing a person using a picture compared to a drawing. While a drawing resembles the original, it will never be as accurate as a picture of the original.

The difference between the picture and drawing is the tracking error, which may be to your advantage or disadvantage, more often than not it results in price deterioration.

Leveraged Tracking Error

The best way to illustrate the tracking error of leveraged (short) ETFs is via a few simplified examples.

The first table shows the mathematical tracking error caused by leverage in a range bound market:

 

The second table shows the tracking error in a trending environment:

 

Assuming that you are betting on the right direction, trending markets tend to enhance the return of leveraged ETFs, while range bound markets are the worst possible environment.

The chart below plots the price of the S&P 500 against the price of the UltraShort S&P 500 ProShares (SDS), a 2x leveraged short ETF.

 

The S&P closed almost at identical prices on May 2, 2011 and February 21, 2012. SDS lost 18% over the same period of time.

Be Picky and Disciplined

Driving 150 MPH on the Autobahn is fun, but comes with added risk. There’s no way to eliminate the extra risk. The best you can do is limit the risk.

The same is true with leveraged ETFs. You can limit the risk of large and unnecessary losses by:

1) Picking your spots: Only buy or sell when there’s a high probability, low-risk entry.

2) Money management: Lock in profits against major support/resistance levels and don’t hold positions for too long. Stick to your stop-loss levels.

The Profit Radar Report’s mission is to spot high probability, low-risk opportunities. Low-risk means that the risk of losing is well defined and much smaller than the potential for gains.

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