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:

Spread ETFs-positive results

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 ([email protected])

www.thebluecollarinvestor.com