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actually some interesting ways to play the downside or hedge your portfolio. [Let me explain.] Words: 990The comments above & below are edited ([ ]) and abridged (…) excerpts from the original article written by Justin Pugsley (www.stockopedia.co.uk).
[You could] dabble in spread betting, contracts for difference, futures and options…[but] the problem with some of these instruments, such as futures, is that you can lose much more than you put into the trade if the market moves against you. Buying options is less risky in that you cannot lose more than you put in, but after a certain amount of time they expire and if the market has moved against you, they soon become worthless.Leveraged Index-based ETFs
Enter exchange traded funds (ETFs) and in particular the leveraged variety, which can move as if on steroids and frequently rank among the most volatile shares on the New York Stock Exchange where they are listed.
At the cutting edge of this turbo charged ETF universe are providers such as Direxion and VelocityShares. Financial institutions such as banks continue to figure prominently in the global crisis and regularly outpace the rest of the stock market on the downside during sell-offs and the Direxion daily finance bear 3X ETF (FAZ), for example, is designed to move three times the Russell 1000 financial services index, but in the opposite direction. So if the index falls 10%, FAZ should rally 30%. Direxion has a whole range of triple leveraged funds, which are indexed against a variety of sectors such as energy, technology, gold, emerging markets, small caps and so on. For each leveraged bear fund there is a corresponding bull fund, for those who reckon 2012 could actually surprise on the upside.
VelocityShares has the VelocityShares daily 2X VIX short-term Exchange Traded Note (ETN) and it’s ticker is TVIX. There is also a medium term 2X velocity ETN with the symbol TVIZ and both are traded on the New York Stock Exchange.
Leveraged Volatility-based ETFs
One major feature of the markets since the global financial crisis got going in 2008 has undoubtedly been volatility where market swings have simply been spectacular on occasion and ETF providers have catered for this as well. Volatility-based ETFs have been around for a while, but more recently leveraged ones have been introduced as well.
[ETFs] have come in for some criticism for not accurately mirroring the indexes they’re based on and frequently under perform them but for the leveraged variety, which under certain conditions can make a 15-20% move in the space of hours, that may not be so important.The VIX is an index which reflects the implied volatility of the S&P 500 index and the VIX is based on prices of put and call options based on the S&P 500.
In practice these instruments work best when the market has gone through a period of calm and then suddenly falls… On the flip side with these funds, FAZ included, stock market rallies can see their value melt away very quickly so their use needs to be judged carefully.
The Pros and Cons of Leveraged ETFs
On the upside:
- you can’t lose more than you put in unlike with futures,
- there are no time issues as with options and yet, on occasion,
- these leveraged instruments can perform just as spectacularly.
- [Unfortunately, however,] you do have currency risk involved if you are [not a USD-based] investor.
There are no free lunches and these complex vehicles do have a number of risks:
- there is counterparty risk and should one of the counter parties the fund has linked up with fail that could be the end of the fund,
- there is roll-over costs. In essence these funds hold futures contracts, so every month they may liquidate their three month futures contracts when a month passes and roll into the next three month contract and that can incur a problem depending on the curve of the market [because] the three month contract might be priced differently to the two month contract, so the fund could effectively be making a loss on the roll over every month, which can chip away at its value. In a ‘normal’ market that shouldn’t make a huge amount of difference and sometimes the fund can actually make money from this process depending on the pricing of these futures contracts.
- Experts advise, especially with leveraged ETFs, that [they not be held]…for long periods of time. They are basically trading instruments and should be used by sophisticated investors only.
Conclusion
Leveraged ETFs are an interesting alternative to the typical derivative instruments available to retail investors (unfortunately, the products described here are only available in the U.S. at the moment, but many UK-based stock brokers offer access to US markets) and it is an area full of innovation with new products coming to the market regularly…
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