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Beware of Leveraged ETFs; The Changing Face of Exchange-Traded Funds

How would you feel if your best friend and next door neighbor was metamorphasizing into a monster? A Dr. Jekyll and Mr. Hyde if you will. Could that be happening to our old friend, the Exchange Traded Fund? The historical definition of an ETF is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. They provide the diversification of an index fund so for those looking to get started in covered call writing with limited cash, this may be an avenue to explore. I have been selling covered call options on the Qs (QQQQ) in my mother’s portfolio for years generating hundreds of dollars per month into her account.

Recently, however, the definition of an ETF has started to change. Some are actively managed and aren’t required to follow the complexion and market capitalization of an index. These more aggressive funds offer the possibility of greater returns but also represent a higher degree of risk and administrative costs. If your mission statement includes risk reduction, you need to be aware of the pros and cons of such ETFs.

Taking this Jekyll and Hyde analogy to a higher level, we now have the introduction of leveraged and inverse exchange-traded funds. Leveraged ETFs, sometimes called “ultra” or “2X”, use futures or derrivatives to multiply the daily returns of an index. Inverse ETFs look to return the opposite of the index, or double or triple the opposite of the return of that index.

After the impact that leveraging had on the real estate industry the past two years and its subsequent devasting effect on our economy, regulators appear to be voicing their concerns. On FINRA’s (Financial Industry Regulatory Authority) website recently, brokers and investment advisors were reminded that these instruments are complicated and usually not suited for retail investors (that’s us folks) who plan to hold them for more than one trading day! The notice continued…..”Due to effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective.”

Paul Justice, an ETF expert with Morningstar, says leveraged and inverse funds are appropriate for fewer than 1% of the investing community, but still have attracted billions of dollars. Wasn’t there a lesson learned from leveraged real estate investing?

Let’s look at two such funds:

The Direxion Daily Financial Bear 3X Shares (FAZ) seeks daily returns of three times the inverse of the Russell 1000 Financial Services Index, is down 85% year-to-date.

The Direxion Daily FinancialBull 3X (FAS) seeks daily returns of three times the Russell 1000 Financial Services Index, is down 67% in this same time frame. Check out these charts and see if these ETFs are right for you:

FAS as of 6-26-09

FAS as of 6-26-09

 

FAZ as of 6-26-09

FAZ as of 6-26-09

These leveraged ETFs do have a place in the portfolio of some. It is important to understand the risks as well as the rewards and make an informed decision based on the facts rather than getting carried away with profit potential alone.

The main point I want to make to all my fellow Blue Collar Investors is that some ETFs no longer represent the relative safety associated with the older generation funds. The previous funds certainly still exist but their offspring have had a genetic mutation that we must be aware of. FINRA seems to be all over this and so should we.

Screen of the Day:

The IBD website has a tool called Screen of the Day. This past Friday’s screen was for great performing small cap stocks. Every so often, I will run such stocks through our system criteria and see if there are any gems to add to my watchlist. I found three:

  • QSII
  • RKT
  • INFA

Below is the chart pattern for QSII, the best looking chart of the three:

QSII as of 6-26-09

QSII as of 6-26-09

Check out all three charts and see if these stocks belong on your watchlist. Remember, placing a stock on your portfolio watchlist does not mean that you will purchase it this month. That depends on other system criteria like ERs, technical analysis for buy-sell decisions , calculations and diversification issues. You can use this technique for equity location with other lists like IBD’s Stocks on the Move or any other quality screening list. For example, from time to time, I will screen the stocks in the top performing industries and see which ones meet our system criteria. Those following this site know that I have reported some of these stocks on the comments link of my blog articles periodically. I encourage you to share your findings with the rest of our group.

Economic News of the Week:

Once again, we see several positive signs of economic recovery, the so-called “green shoots.” Sales of exisiting homes increased for the second consecutive month while sale of new homes remained relatively stable. Personal income increased by 1.4% mainly as a result of the stimulous money. The Fed kept its target rate funds in the 0% – 0.25% range as it anticipates ” a resumption of sustainable economic growth.” The GDP continued to decline but not as sharply as previously anticipated. Durable goods orders increased a surprising 1.8% in May despite predictions of a decline. For the week, the S&P 500 fell 0.3% for a year-to-date return of 2.9%. Those of you paper-trading sucessfully in this volatile environment are in for quite a ride when the market becomes more predictable and turns at least neutral and perhaps even moderately bullish. Your paper-trading due-diligence will be handsomely rewarded.

Video now playing on the homepage:

Selecting the Best Strike Price

 

Last chance for book discount:

As a courtesy to my loyal readers, this is a heads-up notice that the $5- early order discount of Exit Strategies for Covered Call Writing with the Expiration Friday DVD will end this week. Demand for the book far exceeded my wildest expectations and I thank you for that. Here is the link to be eligible for the last minute discount:

/store.shtml

My best to all,

Alan (alan@thebluecollarinvestor.com)

About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

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12 Responses to “Beware of Leveraged ETFs; The Changing Face of Exchange-Traded Funds”

  1. Quong S. Chin June 29, 2009 7:29 am #

    Hi Alan,

    I must’ve been lucky when I bought FAS at $2.48 a share strictly for a speculative play. Since then, I’ve been selling FAS covered Calls where the premiums collected have more than cover the cost for the stock and then some. Of course, this was before I read your book which convince me that your method is better for selling covered Calls.

    There are so many books on Options trading that I must’ve also been lucky when I ordered your book. Thanks.

    Quong

  2. Steve June 29, 2009 12:07 pm #

    Your definition of ROO indicates net from option (assuming intrinsic value deducted if required)divided by cost basis of underlining stock. I am not including for this purpose upside, if any. I have been using the price of the underling stock at time I am selling option to calculate the monthly return. Is this incorrect?

    Thanks,
    Steve

  3. admin June 29, 2009 12:13 pm #

    Steve,

    This IS correct. When selling an A-T-M call or and O-T-M call, your cost basis per contract is 100 x the per share price of the stock. This is your investment.

    When selling an I-T-M strike, I deduct the intrinsic value from the option premium (ROO) and use that to “buy-down” the cost of the stock.
    For example, if you buy a stock for $52 and sell the $50 call for $3.50, the profit is $1.50 per share and the cost of the stock is bought down to $50.

    This is an accounting maneuver we make to help us determine the best option choices to make the most money. It is NOT statitistics to give to your accountant for tax purposes.

    Alan

  4. Stephen Drourr June 29, 2009 2:42 pm #

    Alan, Thanks for the immediate response.
    To make sure if my cost of underlining stock is 30 and I sell the option when the stock is 31 I have been using 31 as the TR/P (transaction price)to divide the ROO by.

  5. admin June 29, 2009 5:02 pm #

    Steve,

    When selling an I-T-M strike, deduct the intrinsic value from the option premium and use it to “buy- down” the cost of the stock to the strike price. In the example you give, if the option premium for sale of the $30 strike was $3, use $2 as option profit and $1 to buy down the cost of the stock to $30. The ROO calculation for 1 contract would then look as follows:

    ROO = 200/3000 = 6.7%

    Let me know if this clears it up for you.

    Alan

  6. Gary June 30, 2009 9:30 am #

    Hi Alan,
    What do you think about LFT. I used to trade it and made good money. Now the price is down a little, but volume is kind of low too. The price is also below 20 day average. Earning report is coming out in August.
    Thanks
    Gary

  7. admin June 30, 2009 10:17 am #

    Gary,

    I curently have LFT on my watchlist. It’s a very strong company. However, because of the recent technical decline in the chart I would either avoid this stock until the chart looked stronger or sell an I-T-M strike. Currently the $22.50 call will generate only about 1% and we can’t go out into August due to the ER.

    Generally in situations such as this one, I would look for a stronger financial soldier and perhaps re-evaluate this one for the September contracts.

    Alan

  8. admin June 30, 2009 2:18 pm #

    AIG proposes a reverse stock split:

    With the current market value of AIG at an incredible $1.16 per share, the Board of Directors is quite nervous. First, it runs the risk of being de-listed from the NYSE if the price falls below $1 per share and more importantly it is losing the interest of institutional investors who avoid equities trading under $5 per share.

    To remedy this situation , the board has proposed a 1 for 20 reverse stock split. This will raise the price of the stock 20 fold and decrease the number of shares by the same denominator. If the split is approved, an investor owning 1000 sharesd @ $1.16 would then own 50 shares @ $23.20. Notice that the market cap of both scenarios are the same : $1160 (price x number of shares).

    Conventional stock splits and their impact on your covered call investments are discussed in chapter 17 of “Cashing in on Covered Calls”.

    Alan

  9. admin July 1, 2009 6:16 am #

    With the upcoming extended 3-day weekend, there is a strong probability that we will see a decreased trading volume today and tomorrow as institutional investors either take additional time off or are hesitant to take new positions prior to the long market weekend.

    Low trading volume renders changes in technical indicators less vaild. For example, if the share price of your stock breaks slightly below it’s moving average on low volume, I give it less credence than had it done so a strong volume.

    You may want to review pages 77-79 in “Cashing in on Covered Calls” where you will find a discusssion of volume as a technical indicator.

    Alan

  10. Susan July 1, 2009 4:58 pm #

    I sold in the money options on these stocks:

    netl, ctrp, trlg, cern, ntes, pwrd and wms.

    All but one (ntes) are going great. Really excited.

    Thanks,
    Susan

  11. admin July 2, 2009 11:45 am #

    Email questions from Dave:

    Hi Alan, I’m reading your exit strategies book and have two questions.

    1) For the 20% rule why not just put in a buy order at that price as soon as you sell the call? I’ve seen cases where the stock and option will just take a dip during the day and if you weren’t watching you would miss it.

    2) In several of your examples the stock is trading below the 20d ema. How long do you let a stock do that before you get rid of it?

    Thx,
    Dave

    My responses:

    1- Placing a buy-to-close order at the time of the sale of the option is ceratinly one way of handling your exit strategies. This would be placed @ 20% of the sale and later in the contract period changed top 10%. This would be particularly useful if you can’t monitor your positions on a regular basis. Excellent observation and suggestion.

    2- The charts in “Exit Strategies for Covered Call Writing” are 30-d charts and NOT APPROPRIATE OR INTENDED FOR TECHNICAL ANALYSIS OF THE STOCK. The charts are used to show the association of the option premium compared to the price movement of the stock. Understanding this relationship will make exit strategies easier to execute.

    Thanks for two GREAT questions.

    Alan

  12. admin July 4, 2009 4:05 am #

    Is it possible to increase the value of our stocks through careful manipulation of our option positions? There are times when this is possible and we should all know about this. Check out my upcoming journal article and be sure to have pen and paper handy!

    HAPPY 4th to all,

    Alan

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