A smarter way to use leveraged ETFs

Double and triple leveraged ETFs were constructed to serve mainly as short-term trading vehicles. The reason behind is that they reflect the daily change in the underlying index (or basket of stocks).

Let assume that a triple bullish ETFs is promoted at the market with a starting price of $100. If the price of the underlying index goes up 10% for the day, the price of our leveraged beast will rise to 130 (3 x 10% x $100). If, on the very next day, the price of the underlying index drops 10%, the triple levered ETF should drop by 30% x 130 and to trade at 91 by the end of the day. The net result from those two trading days is 1% drop for the underlying index and 9% drop for the triple levered one. It is a simple mathematical rule. 10% drop in a price is recovered by 11.11% rise and 10% rise in price is erased by 9.09 drop. The levered ETFs are computed in a way that you might greatly benefit by this mathematical rule during certain market conditions.

November 2008 was the birthday month of triple leveraged ETFs. Two of the first were TZA and TNA, which were supposed to reflect 3 times the daily change in Russel 2000. They were both promoted at a price around $60 per share. Let assume that you were aware of the above mentioned mathematical rule and decided to short 50,000 worth of TZA and 50,000 worth of TNA in order to hedge your position. The net results is that you are short 834 shares of TZA and short 834 shares of TNA. Three and a half months later, the triple bearish TZA is traded at $56 and the triple bullish TNA is traded at 25. You decide to cover your short positions and in TZA you make $4 per share or $3,336 for the position; in TNA you make $35 per share or $29,190 for the whole position. The net result is $ 32,526 gain or 32.52% for 3.5 months. For the same period Russel 2000 is down about 16%.

This strategy provides best results and is safer to be used in range-bound markets, since more often retracements to a moving average will have higher depreciating effect on both levered ETFs. During periods of strong trending markets, the strategy could be detrimental for your portfolio if you don’t have percentage stops in place. Nothing goes straight up or down, but there are always exclusions and you should consider them in your risk management models. Chose levered ETFs that are well diversified, representing various sectors.