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Leveraged ETF’s, despite their significant risks (counterparty risk correlation risk to name a few), are gaining in popularity.  There are several institutions offering double exposure ETF’s, and now a new entrant is even offering TRIPLE EXPOSURE ETF’s.  Here is a sampling of the leveraged lineup:

• Proshares - offers single and double exposure index, sector and international ETF’s.  Also offers inversed double exposure ETF’s.
• Rydex - similar offering to that of proshares, with 14 double exposure ETF’s.
• Powershares -In general, their ETF’s hold fewer positions than traditional ETF’s, but they are not leveraged as of yet.  But I do like their dollar bull ETF (symbol UUP).
• Horizon Betapro ETF’s – Offers HBP Bull+ ETFs for double the daily performance of their underlying equity index or commodity, and HBP Bear+ ETFs for double the daily performance opposite that of the underlying index or commodity.
• Currencyshares – Not quite a leveraged lineup, but certainly worth mentioning.  These ETF’s offer a convenient way to bet on foreign currencies.  Personally, I’m more of a dollar bull then ever, but I do like the Japanese yen strength these days.  The symbol is FXY, but buy it at your own risk!
• Direxion Funds – Currently offers 1.25x and 2.5x leveraged ETF’s.
• Direxion Shares – In an industry first, they will soon offer triple leveraged (300%) ETF’s.  There will be 16 available, including the Large Cap Bull 3X (BGU), Small Cap Bull 3X (TNA), Large Cap Bear 3X (BGZ) and the Small Cap Bear 3X (TZA).

The most interesting fromt he list above are the new 3X leveraged ETF’s.  From the prospectus, there are numerous risks associated with these ETF’s.  The ones that stand out to me are:

• Correlation risk – In a nutshell, it’s virtually impossible to achieve exactly 3X the performance of the index, so don’t be surprised if the underlying goes up 1% and the 3X ETF only goes up 2.5%, and vice versa.
• Counterparty risk – Direxion uses counterparties that have access to financial instruments used to target those 300% returns.  There is no guarantee that those counterparties are, or will remain solvent in the future.  (Hint:  Bear Sterns, Lehman Brothers)  From the prospectus, “The Funds will not enter into any agreement involving a counterparty unless the Adviser believes that the other party to the transaction is creditworthy“.
• Credit risk – From the propsectus, “A Fund could lose money if the issuer of a debt security is
  unable to meet its financial obligations or goes bankrupt”.

More on correlation risk – In general, the leveraged ETF issuers do not disclose their methods for achieving 2X or greater leverage.  With the 2X funds, my own speculation tells me that the counterparties involved are either double short or double long the underlying.  The counterparties pay significant margin interest which is then passed on to the issuing fund (proshares or rydex for example), and eventually to the investors.  But with 3X funds, it’s more likely they need to access the futures and options markets to achieve the triple leverage.   If so, that could significantly increase the correlation risk for the following factors:

• Time decay – Options and futures have time premiums and time decay, which could cause more correlation differences in the 3X funds.
• Spread risk – The BID/ASK spreads on options and futures is increasing with the increasing volatility of the markets.  The institutions certainly would get the best prices, but the spreads are still not free, and the options/futures spreads are certainly larger than the spreads on stocks and ETF’s.
• Liquidity of options and futures market – It’s great for amateur investors, but if these 3X funds take off, they could find it difficult to roll contracts due to the volume involved.

Also check out:

• Correlation Error With Leveraged ETF’s

If you have been successful with covered calls, then you you may also want to study up on calendar spreads. A calendar spread is essentially a covered call on steroids, and can be used when you expect a sideways or gradually moving market. But managed correctly, it can also benefit greatly from the trader that can effectively adjust from LEAP to calendar spread and back again.

Let’s start with the LEAP, which stands for long term equity anticipation securities. They are structured similarly to standard equity options, but have longer expiration periods. LEAP’s have January expirations and are currently available in many equities and indexes with a January 2009 or a January 2010 expiration. The extrinsic value (time premium) of a LEAP is going to be much greater then a front month option. But overall LEAPs will be much less expensive then purchasing a security or index outright. LEAPs are also less volatile then front month options due the extra time involved.

A buyer of a LEAP call option believes in the long term appreciation of the underlying security. But let’s examine a scenario that maximizes the return of a LEAP by taking advantage of front month price action and volatility.

The hypothetical ABC company sells computers, music players and cell phones. They currently trade for $157 per share. 100 shares of ABC would cost $15,700 out of pocket, but the January 2010 LEAP in ABC, at strike 150, goes for only $41 ($4,100 per contract). The breakeven point of this particular LEAP option is the strike price plus the option price or $191. The ABC company needs to get to $191 per share in January of 2010 just to break even. It needs to move over $191 to make a profit.

Assume that an investor buys a 2010 strike 150 LEAP in the ABC company on July 29, 2008 at a time when the ABC stock sells for $157. Option pricing is not an exact science, but suppose the ABC shares rally to $167 on July 27. The Jan 2010 150 LEAP contract may also move from $4,100 to $4,900 at the same time, for a healthy 19.5% gain on investment. But using the LEAP as a cover, the trader could then sell a front month option in ABC to potentially increase that profit. The August front month 170 call option might go for $4 ($400 per contract) with ABC just shy of 170. If ABC hits August expiration at under 170, then the August 170 call expires worthless, leaving the entire $400 premium collected as additional profit. But even if ABC nears August expiration slightly above 170, the front month August option could still be bought back (BUY TO CLOSE) for potentially less then you sold it for. In that case, you profit from the rally in the LEAP, plus the additional profit gained from the front month August contract. When you close out the August front month contract – either buying it back or letting it expire worthless – you have effectively gone from LEAP to calendar spread and back to LEAP again.

For additional reading, please CLICK, BUY and READ:

Disclaimer:  Investing and/or trading is dangerous and you can lose money.

What gives? It now seems that every other day the market is up or down two percent or more. We all know that what really drives the big moves is the big money. But I’m not convinced that the big money is actually the smart money, especially when viewed in context of huge 2 percentage point swings every other day. To say we are in a volatile market is an understatement, and many people are just pulling out to sit in cash – what little they have left – as they wait for calmer waters. But if you still want to play, here are 3 strategies to consider that can work in high volatility markets:

1) Covered calls – An investment strategy where the investor has a simultaneous long position in 100 block increments of a security, and a short call against those positions. The short call acts as a minor downside hedge, and can also offer enhanced returns on the upside.

• the vix index and covered calls
• Time for cover – the covered call
• Covered calls – removing the covers and going naked

2) Calendar Spreads – Covered calls on steroids. Instead of owning the actual shares to sell calls against, a trader buys longer term options – LEAPS – to sell shorter term options against.

• From LEAP to calendar spread and back again

3) Iron Condors – Short term option strategy involving two simultaneous credit spreads composed of four individual option legs. The Iron condor trader hopes to make consistent monthly income of 5-25 percent. The higher your target income range, the more risk you take on. My personal favorite is to use monthly iron condors against the Russell 2000 index.

• Iron condor traders can make 25 percent per month

For additional reading, please CLICK, BUY and READ:

Covered Calls and LEAPS–A Wealth Option + DVD: A Guide for Generating Extraordinary Monthly Income (Wiley Trading) by Joseph R. Hooper

Option Strategies for Directionless Markets: Trading with Butterflies, Iron Butterflies, and Condors by Anthony J Saliba

Disclaimer:  Investing and/or Trading or Speculating is dangerous.  You can lose money.

I’m a big fan of the free investment web tools (Google finance, Yahoo finance, MSN money), but I’ve always stated that the fee based tools are worth the money. The free information is quickly closing the information gap on the pay services, just a bit more scattered and time consuming to find. Sector rotation and industry ranking information is one key feature of many fee based financial tools, but I just stumbled across the Prophet.net site that gives it away for FREE!

Here is the top portion of a basic snapshot of the prophet.net industry rankings:

The image above only shows the higher rated industry groups so they are all green, meaning that the money is flowing into these industry groups. On the prophet.net website you can see the entire performance grid, including the bottom ranking industry groups (anyone want to take a guess?).

This layout of the chart is remarkably similar to the investools big chart, but with a few more bells and whistles. You can change the view of the prophet.net chart to either historical trends or current performance. I personally perfer the historical information, as shown in the image above. The trending is read from right to left, with the most recent data on the left. The numbers in the chart are industry group percentiles, as compared to other groups. In a nutshell, the higher the number, especially when trending upwards from week to week, signifies that big institutional money (mutual funds, pension plans) is flowing into that industry group.

The information is particularly valuable for ETF investors who want to be in the next heated sector. It’s also useful for those that want to maintain hedged portfolios using pairs of ETF’s – one long and one short for example. The proshares inverse ETF in an out of favor group could act as the downside hedge, along with an upside play on a hot performing group.

The VIX was introduced in 1993, and is used by many as a barometer of investor sentiment and market volatility. It is designed to show the market’s expectation of 30 day volatility. And since volatility is one of the main parameters used to determine theoretical options prices (along with stock price, strike price, interest rate, time and dividends), it’s a good idea to monitor the VIX as you write covered calls against your positions.

All things being equal, higher VIX numbers will allow you to sell your covered calls for a higher premium. For historical comparison, the range of the VIX in 2005 was 10.23 to 17.74. The markets were not as volatile in 2005 as they were today, and covered calls did not yield as hefty premiums as they do today. Today, the VIX closed at 25.78, well above the high range mark of 2005. Selling covered calls in today’s high volatility environment can be potentially very rewarding. In general, I want to be a buyer of options when the VIX is low and a seller of options (covered calls or calendar spreads) as the VIX increases. You can still make money buying options in high volatility (high VIX) environments, but you also have greater risk of the volatility crush, where your options positions decline in value significantly as the volatility of the market decreases quickly.

Yesterday I mentioned a simple way to hedge a portfolio using either the profunds or proshares. Today I will offer a sample portfolio that demonstrates a simple hedged portfolio that has yielded an impressive 15.1 percent return year to date. The portfolio below is NOT A RECOMMENDATION. It is simply a backtest demonstration of a 4 way combination of proshares ETF’s and what the strategy would have returned this year. This particular sample portfolio is comprised of the following:

• Proshares Ultra Technology ETF (symbol ROM) – bullish on technology
• Proshares Ultra Oil and Gas ETF (symbol DIG) – bullish on energy
• Proshares Ultrashort S&P 500 (symbol SDS) – bearish on the market in general, to hedge other positions
• Proshares Ultrashort Financials (symbol SKF) – bearish on financials, also used to hedge other bullish positions

If you decide to use proshares to either enhance or hedge your portfolio, you will have to determine the best combination that suits your own investment style and bias. The results below are just a quick demonstration of their usefullness. The strategy assumes purchasing 100 shares of each of the 4 proshares ETF’s on January 2, for a total outlay of $34,249. As of today, such a portfolio would be valued at $39,418, for a cumulative YTD return of 15.1%. This compares very favorably to the current S&P YTD return, which at last glance was DOWN 11.2% YTD.


Details of this simple backtest are below. You can try your own combinations to see how this combination and hedged strategy would have worked for you.

If you are in mutual funds, your fund manager generally only has two choices – cash or equities. A conservative and well hedged fund manager will maintain a reserve cash position during times of lofty valuations. When prices return to a decent value, the fund managers with cash on the sidelines can swoop in to steal the value. But what if you think valuations are to high at any level, and the US is headed for a major downturn? Or what if you buy into the current valuations, but you just can’t stomach the wild ups and downs of the market? This is where the inverse funds and shares come into play. Profunds and proshares are two such vehicles for easy portfolio hedging, or downright bets against the economy.

The difference between the profunds and the proshares offerings are the same as the difference between mutual funds and exchange traded funds. I personally personally prefer ETF’s for the following reasons:

Benefits of ETF’s

• Intraday trading (mutual fund purchases and sales are settled only at end of day pricing)
• Lower expenses then mutual funds
• Tax efficiency (mutual fund owners get hit with end of year distributions)
• You can short and even write options with ETF’s

The proshares ETF’s offer low fee methods to gain exposure to market indexes. But through their ultra shares, short and ultra short shares, they also offer an innovative way to manage risk and enhance return of your portfolio. The list of proshares is available here. My personal favorite is the Ultra Short S&P 500 shares (SDS), the objective of which is to double the inverse performance of the S&P 500. I’ve used it in the past as a downside hedge to my otherwise mildly bullish portfolio, and have also sold short term options against it.

The profunds offerings are similar in nature to proshares, but using mutual funds instead of ETF’s. The Ultrabear profund seeks to double the inverse of the S&P 500. There are also classic profunds, ultra profunds, and sector profunds to choose from.