01 April 2009

Proper Use of Leveraged ETFs

Trader Mike alerted me to this interesting article by David Penn of Trading Markets regarding the proper, i.e. short-term, use of leveraged ETFs:

However, a closer look at leveraged ETFs warns that in the longer run, leveraged ETFs may not provide long-term investors with the kind of returns their 2-to-1 or 3-to-1 banners suggest. Between fees and the unique way that leveraged ETFs are structured, investors who rely on leveraged ETFs may end up getting significantly less than 2-to-1 or 3-to-1 on their leveraged ETF investments. And although this does not mean that investors and position traders cannot use leveraged ETFs to good effect, it does mean that investors looking to leveraged ETFs should in some ways temper their expectations and, if not “do the math” first, at least be sure they read the fine print.

For short-term traders of ETFs, though, many of the problems that leveraged ETFs bring to investors are not problems at all. Because of the relatively short holding period of five to eight days, short-term ETF traders have a far better opportunity to reap the benefits of 2-to-1 or 3-to-1 leverage without many of the drawbacks that longer-term ETF investors must face.
What does this mean for traders? Not as much as the financial press will lead you to believe. Traders are in positions only a few days and when they trade these ETFs, they are not hurt much (if at all) by the rebalancing costs. Hold these ETFs for many weeks and months, and returns will potentially underperform. But trade them for a few days as TradingMarkets does, and a trader will be fine. A look at a classic, short-term trading strategy using ETFs shows how it applies to the world of leveraged ETFs.

Penn continues by advocating the two-period RSI swing trading strategy that I often use and describe on this blog.

Go me.

Otherwise, the moral of the story is, if you want long-term long or short exposure to indices or sectors, stick to buying and holding straight-up unleveraged ETFs. But if you are looking to juice your returns in the short-term, the leveraged ETFs are the preferred vehicle.

No comments: