Legacy Funds

Liquid – Transparent – Alt Investment Strategies

A method for trading leveraged ETFs

Leveraged ETFs keep making headlines, and more so than usual lately.  There is a lot of mystery and conclusions ranging from these are fraudulent vehicles to these are powerful tools that can help the retail investor generate hedge-fund like returns. If you have read any of my comments, I obviously belong in the latter group.  However, I do agree without knowing how to trade and manage the risk, these do end up feeling like another fraudulent gimmick because the losses come fast and furious.   Trading these on fundamental analysis alone will not work due to the time decay.  There definitely is a lot of complex math behind what is going on to result in this time decay:  basically one is long gamma and short volatility so ending up with time decay or theta. However a strong trend can offset and even outgain the losses from decay.  Furthermore, you don’t have to know the math behind it, just like I don’t have to know the intricate details of my car engine in order to drive. I need to know the basics…accelerator, brakes, steering wheel… so I can safely drive the car. So for these leveraged ETFs the main thing you need to know is to use them in the direction of the trend and to get out quickly when that trend is threatened — so you need a short term trend following strategy with position sizing and risk controls. Since you are trading in the direction of the trend, and these come in pairs, there is something that can be traded when the market is trending up or down, how nice is that…

So let’s move on to a very simple trading strategy.  This one will utilize a single moving average, and for our purposes today we will use a 21 dma.  As you get more proficient you can use moving average crossovers, moving averages in different time frames for confirmation of a shorter time frame signal, etc. But just a simple 21 dma will at the very least keep us out of trouble by providing some level of brakes (to go back to the car analogy) to avoid a crash. Let’s try this on QID (the double inverse QQQQ):

sc

Obviously we don’t have a buy signal since it is below the 21 dma. QID is bought when the price crosses over the 21 dma, and sold when the price crosses below. Let’s check out QLD (the double long QQQQ):

sc

As you can see, QLD triggered near mid July, and it has been long since. You can see other times where it triggered and was profitable, and some times where it triggered but the trend didn’t continue. There are times when you have to sell only to get back in when it gets back over the line again, sometimes at a higher price then you sold. Just consider these whipsaws the cost of having protection from the big drops — look at late August of last year to see the size of QLD’s decline from that point. It is no surprise that it was the start of a very profitable uptrend in QID.

Look at past charts, and paper trade a large variety of these leveraged ETFs to give you a feel for how they trade. Next time I will cover how to set an initial stop loss, how to use that to size your position, and how to keep adjusting the stop loss as your ETF trends. Feel free to comment if you have any questions.

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August 3, 2009 - Posted by | Legacy Funds | , ,

6 Comments »

  1. Suzanne, good post, well written and explains a complex topic in plain english. Levered and inverse ETFs have received a good deal of bad press, and frankly the average retail investor probably shouldn’t be using them. However in the hands of professionals like yourself these are great tools to enhance return and control risk.

    Comment by Roger Wohlner | August 19, 2009 | Reply

    • Thanks Roger, I am honored by your comment. As I have been posting on a number of forums the statement by Finra “Leveraged and inverse ETFs can be appropriate if recommended as part of a sophisticated trading strategy that will be closely monitored by a financial professional.” says it all. These are great tools, especially in retirement accounts that otherwise wouldn’t have the ability to short.

      Comment by Suzanne Hamilton | August 19, 2009 | Reply

  2. Portfolio theorys says buy the efficient frontier. As long as the investor has some risk tolerance, that implies a leveraged portfolio consisting of representative slices of the market.

    So a long term individual investor who buys index funds and ETFs could use leverage ETFs to reach the optimal point on the efficent frontier. Of course, one could simply buy index ETFs in a margin account. But my gut is that leveraged ETFs have lower borrowning costs than most individual investors.

    The key is some sort of rebalancing of the leveraged ETF holdings.

    By doing so you can make these leveraged ETFs track a long term return as opposed to a daily return.

    Might be the missing ingredient for a sophisticated individual investor who might otherwise simply take cash positions in index securities.

    Comment by Roderick Beck | August 30, 2009 | Reply

    • Yes, in theory this is a great plan, and thanks for providing your input. In reality there are a number of assumptions one has to make. One has to have an unwavering belief in portfolio theory and the efficient frontier. One has to stick through this even if the market and all assets correlate and correct in unison to lower lows then we have already witnessed. Furthermore, my hunch is the costs of rebalancing these ETFs to be long term holds exceeds the borrowing costs.

      I see these ETFs as lending themselves more for market timing based on some technical indicator (not discretionary market timing — which unfortunately is the way some traders use these).

      Suzanne

      Comment by Suzanne Hamilton | August 30, 2009 | Reply

  3. Suzanne,
    I very much appreciate your commentary. I would like a follow up to your article on “trading leveraged ETFs;” specifically two other tools you mentioned in that story..entry points and other time frames used for corroboration of 21 day MA.

    Best to you,
    Abelardo

    Comment by abelardo barroso | January 31, 2010 | Reply

    • Abelardo,

      You can get better confirmation by using longer duration MAs to increase your chances of being in the right direction of the trend. For example, you can use the 21 dma but require that the ETF has to be above for example the 50 dma as well in order to take a long entry.

      Hope this helps a bit,
      Suzanne

      Comment by Suzanne Hamilton | February 2, 2010 | Reply


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