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Complex and Leveraged Exchange-Traded Funds

With more and more Blue Collar Investors using online discount brokers as their trading platforms the need to be aware of the risks of complex and leveraged exchange-traded funds has become critical. Buyer beware! Covered calls can be written on many of these securities but is the risk justified? First let’s review some definitions previously discussed on this site and then we’ll add a new one (Spread ETFs): 

Leveraged ETFs 

These securities are designed to follow daily changes in stock market indexes and then use financial derivatives and debt to magnify the returns. A leveraged ETF with a 2:1 ratio will return 2% if the corresponding index returned 1% that day. However, the same hypothetical applies to losses

Inverse ETFs 

Use derivatives to bet against the direction of financial markets. These are known as short or bear ETFs and will make money if markets decline in value. They will lose money, however, if market s move against the bet. Covered call writers who have a bearish market outlook may find these funds useful.

Spread ETFs 

Combine two indexed positions- one long and one short- into a single ETF. One market segment is purchased while another is sold. It combines a bullish and a bearish outlook into a single strategy. Profit is generated from the difference in return between two market segments. In these instances price relationships are more important than specific prices. 

More on Spread ETFs 

Spread ETFs invest equal dollar amounts (not necessarily equal numbers of shares) into each market segment. This dollar amount is rebalanced daily for dollar neutrality. This is the standard practice where both sides are equal in dollar value so as not to be net long or short in the market.

Let’s first look at a hypothetical investment of $100 into a spread ETF. This gives the investor $100 of long exposure to a long sub-index and $100 of short exposure to a short sub-index. This spread ETF is leveraged 2:1 because a $100 investment provides $200 of market exposure. If the long index returns + 1% in a day and the short index returns – 1% in the same day the investor will realize the difference between the two or + 2% as seen in the chart below:

Complex ETFs

Spread ETFs-positive results

 

On the other side of the equation, if the long index returns – 1% and the short index returns + 1% on the same day the investor will realize a loss of – 2% as seen in the chart below:
Leveraged ETFs

Spread ETFs-negative results

 

There are also Leveraged Spread ETFs which target a magnified return of the difference in daily return between a long sub-index and a short sub-index. These securities employ additional leverage which carries with it greater risk of loss. 

Examples: 

2x S&P 500 Bull/ T-Bond Bear (FSE): For investors who believe that the large-cap US equity market will increase in value relative to the long-dated US Treasury market over the next day. 

2x T-Bond Bull/ S&P 500 Bear (FSA): This fund takes a short position in E-mini futures and a long position in Treasury Bond futures, the counterpart to FSE. 

Conclusion on Spread Trading 

Spread trading allows a trader to benefit from the price difference between two market segments. Spread ETFs simplify the process by enabling investors to hold the two market segments in one convenient and cost-effective security. Leveraged Spread ETFs increase both potential returns and losses.

Conclusion for covered call writers:

Not all funds are created equally. In the eyes of this investor, covered call writing is a conservative strategy for conservative investors which has simplicity as one of its benefits. This is why we do not include leveraged and complex ETFs in the ETF reports we provide to our premium members. For most Blue Collar Investors, the use of complex and leveraged ETFs may represent unnecessary risk of products not fully understood. There are a huge variety of standard ETFs that will meet the goals and objectives of covered call writers and this is the place most of us should be. However, I believe that it is important to recognize the variety of new products being made available so we can weed out the ones that do not apply to our investment objectives and that is the purpose of writing and sharing this article. More sophisticated investors may benefit from these more complex securities.

Live seminars for 2013

January 19th: Milwaukee Chapter of the American Association of Individual Investors

February 18th: The Money Show’s NY Stock Traders Expo @ the Marriott Marquis Hotel

March 21st: JUST ADDED: South Florida Options Trading Meetup in Coral Springs

Register here: http://www.meetup.com/options-fl/events/99584332/

April 20th: Atlanta Options Investor Club @ Georgia State University

May 14th: Long Island Stock Trader’s Meetup in Plainview, NY

June 8th: Baltimore Chapter of the American Association of Individual Investors

September 17th: Philadelphia Chapter of the American Association of Individual Investors

November 9th: Chicago Chapter of the American Association of Individual Investors

Market tone:

This site continues to be long term bullish and the past week’s economic reports only support that position:

  • Housing starts increased by 12.1% over the past month, the best performance since January, 2008
  • Single family homes increased by 8% while multi-family homes by 20%
  • Annualized housing starts rose by 82% in the 4th quarter compared to the 3rd quarter, the best increase since the 1980s
  • In 2012, builders started 708,000 homes, the most starts since 2008
  • The Beige Book showed that ALL 12 districts of the Federal Reserve reported growth over the past 2 months
  • Consumer spending also rose in all regions
  • Retail sales in December rose by 0.5% compared to the 0.2% anticipated
  • Business sales increased by 1.0% in November after a 0.3% decline in October
  • Consumer and producer prices showed that price inflation remains under control
  • Initial jobless claims for the week ending January 12th came in at 335,000, less than the 365,000 anticipated
  • Industrial production rose by 0.3% in December as manufacturing output increased by 0.8%

For the week, the S&P 500 rose by 0.9% to 1486.

Summary:

IBD: Confirmed uptrend

BCI: Long-term bullish and short-term cautiously optimistic selling an equal number of ITM and OTM strikes

Thanks for being part of our BCI community.

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

 

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About Alan Ellman

Alan Ellman loves options trading so much he has written three top selling books on the topic of selling covered calls alone. He is a dentist by day, a personal trainer, successful real estate investor, but he is known mostly for his profound stock option strategies.

12 Responses to “Complex and Leveraged Exchange-Traded Funds”

  1. Barry Bergman January 19, 2013 4:55 pm #

    Premium Members,

    This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 01-18-13.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    Since Earnings Season is in full swing right now, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:

    http://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

    Best,

    Barry and The BCI Team

  2. Alan Ellman January 19, 2013 6:18 pm #

    BCI community:

    My team and I will be returning to our office late tomorrow after our seminar in Milwaukee. It was a great venue, a sellout crowd not to mention a delicious lunch. Thanks to the AAII Chapter for your hospitality and to the BCI members who attended. We will catch up with emails during the week.

    Alan

  3. Ken January 20, 2013 4:11 pm #

    Hi Alan,

    I heard you mentioned QQQQ often. If I type the ticker name QQQQ on TOS Charts, it does not show data, type the name on Analyze, it says “Instrument QQQQ has no options”. What have I done wrong?

    • Alan Ellman January 20, 2013 4:23 pm #

      Hi Ken,

      The ticker symbol for the Qs was changed to QQQ (one less “Q”). Try again and you should get the info you’re looking for.

      Alan

  4. Alan Ellman January 20, 2013 4:33 pm #

    My own plane!

    Linda and I just returned from Milwaukee AAII’s Winter Retreat Event, it’s largest meeting of the year. We toured the local museum and ate at several outstanding restaurants including 8-Twelve, Aaron Rogers (football player, ladies) new restaurant and met a fabulous group of investors. Coming home to NY we had an interesting experince with Southwest Airlines. Have you ever been on a flight with only 13 passengers? Now I know how Warren Buffett travels. Check out the picture below (click on image to enlarge and use the back arrow to return to this blog).

    Alan

  5. Shirley January 21, 2013 10:31 am #

    Alan,

    I’m a new member and excited to begin taking control of my finances. I need you to clarify one point about the stock report. Are all the stocks in the gold rows not eligible for the Febraury options. If so, it seems like more than half are eliminated. Please explain.

    Thank you.

    Shirley

    • Alan Ellman January 21, 2013 2:55 pm #

      Shirley,

      The stocks highlighted in the “gold” rows are projected to report earnings during the February contracts are not eligible UNTIL AFTER THE REPORT PASSES. For example, six of these equities are scheduled to report in the first week (above broken black line) and will still have 3-weeks of time value left before expiration. Also, check out our weekly ETF reports which are candidates where earnings is not a factor.

      Great to have you as a premium member.

      Alan

  6. Saul January 22, 2013 7:05 pm #

    Alan,

    The option chain fo BLK shows strike price in 5 dollar increments up to 200 and then 10 increments after that. Is this typical or unusual?

    Thanks for your great work.

    Saul

    • Alan Ellman January 23, 2013 8:15 am #

      Saul,

      Because of the exponential increase in the number and type of option products there are exceptions to the following rule:

      Option strikes trade in $2.50 increments up to $25, then in $5 increments up to $200, and in $10 increments above $200.

      Alan

  7. Mark January 23, 2013 6:03 pm #

    Hi Alan,

    I just wrapped up a very successful January option period. Thanks to you and your system!!! :)

    Now as I am looking for cc positions for February I am having a hard time finding stocks that passed the screening tests that also have a good return (2%+ for ATM or slightly ITM). I assume this is mostly a function of the very low volatility…I don’t think the VIX has been this low since 2007.

    Anyway, my question is what advise would you give for this situation?

    - Look for additional return on OTM positions? (Your summary suggests equal numbers of ITM and OTM positions right now.)

    - Wait for returns to potentially improve over the next week? (How quickly do you try to establish your positions each month?)

    - Go ahead and open positions with about a 1.5% return?

    - Other ideas/advice?

    Thanks in advance for any advice you have.

    • Alan Ellman January 24, 2013 9:31 am #

      Mark,

      Four times a year (earnings season) we are challenged because of the large percentage of stocks ineligible until their earnings reports passes. I’ve published an article explaining a few ways to circumvent this issue:

      http://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

      I like to enter my positions no later than the first week of a 4-week contract and in the first 7-8 trading days of a 5-week contract due to time value erosion of the premiums. Although my goal is normally 2-4%, if I am unable to find enough candidates during earnings season, 1 1/2% will suffice. I actually use a goal of 1-2% for ETFs which I use in my mother’s account.

      CONGRATS on your recent success!

      Alan

  8. Alan Ellman January 24, 2013 6:20 pm #

    Premium members:

    This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options.

    For your convenience, here is the link to login to the premium site:

    http://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    http://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

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