Skip to main content

Trading leveraged ETFs? Stops are essential. Here's how to do it right.

Trading leveraged ETFs, ProShares or Direxion ETFs, for example, comes with a significant amount of risk, especially if the market begins moving against you.

This is why advisers recommend using a stop loss order. Often referred to simply as a stop, it directs your brokerage to automatically sell a stock or ETF if it falls to a pre-determined level. This is intended to limit an investor's loss on an investment.

There are essentially two kinds of stops:
  1. A hard stop that causes the stock to be sold if it hits a particular price.
  2. A trailing stop that causes a stock to be sold if it falls a particular percentage from the most recent high
With leveraged ETFs it can sometimes be tricky setting stops. An investor must evaluate the underlying index and translate that evaluation into an appropriate stop for the leveraged ETF. This is necessary because the price action of the ETF is totally dependent on the performance of the underlying index.

Some ETFs are leveraged 2X, such as the ProShares ETFs. Others are leveraged 3X like the Direxion ETFs. Moves in the underlying index will tend to be exaggerated in the leveraged ETF so it is very important to understand how the leveraged ETFs will react.

Further complicating matters, leveraged ETFs generally track their benchmarks, or underlying indexes, accurately on a daily basis. The companies that offer these ETFs make no claims that they would do so over time periods greater than one day. Nevertheless, many investors do hold leveraged ETFs over longer periods of time and the results can sometimes be unexpectedly extreme.

An example --

An investor may be comfortable taking a 5% loss in an underlying index ETF that tracks the Russell 2000 like IWM, for example. The 5% decline may take the ETF below a support level or trend line and the investor feels that would be a signal to exit the position.

In the unlikely event that the 5% decline happened in one day, what would happen to the corresponding leveraged ETFs? If the investor was holding the ProShares Ultra Russell 2000 (UWM), that 5% loss would become a 10% loss. If the investor instead held the Direxion Small Cap Bull 3x Shares (TNA), the loss would have been further magnified into a 15% loss. Ouch!

Due to the way leveraged ETFs work, a 5% decline over several days would have left the investor worse off than if the decline had happened all in one day.

This implies that investors holding leveraged ETFs may want to evaluate their stops on a daily basis. For those who are day trading the Direxion 3X ETFs, this should be a natural process.

To make it easy to run some "what if" scenarios on leveraged ETFs I have created a simple stop calculator. You can enter the current price of an underlying index or ETF and the current price of 2X or 3X leveraged ETFs. Play around with changes in the price of the underlying index or ETF and see what happens to the leveraged ETFs. Trust me, it can be eye-opening.

Conclusion --

Leveraged ETFs are great for hedging or for attempting to juice up a portfolio; however, they should come with a "Handle with Care" sticker. The most important way to be careful with these ETFs is to limit the damage they can do if the trade goes against you. Carefully consider your use of stops and employ the TradeRadar Stop Calculator to help you determine the best way to protect your portfolio.

Disclosure: none

Comments

Popular posts from this blog

Unlock Stock Market Profits - Key #1

This is the first in an ongoing series of articles where I discuss what I feel are keys to successful investing. It is based on a post that provides a summary of the ten keys that individual investors should use to identify profitable stock trades. ( Click here to read the original post ) There are two basic steps to investing. First, you need to find stocks that seem to have some potential. Then you have to determine whether these stocks are actually good investments. There are many stocks that at first glance look interesting, but further research reveals that there are too many negatives to warrant taking a position. This first post in the series starts at the beginning: getting good investment ideas. Key #1: If something special is happening to a stock, it will be reflected in some kind of unusual activity in the markets. As individual investors, we will never be the first to know; however, unusual activity can be an early sign that allows us to follow the Wall Street profess

Unlock Stock Market Profits - Key #4

This is the fourth article in a series of posts describing 10 tools to help you identify and evaluate good investing ideas. It is based on a post that provides a summary of the ten keys that individual investors should use to identify profitable stock trades. ( Click here to read the original post ) With this fourth post, we will continue another step along the path of finding stocks that seem to have some potential. The first post in the series discussed how to use unusual activity to identify investing ideas. The second post described how to use stock screeners. The third post described how to use lists of new highs and new lows. This post will focus on identifying social or business trends in order to find investing ideas. Information on new trends might turn up anywhere. In conversation with friends or business associates, in newspapers or magazines, on TV or though your work. The key is to be aware of trends and how they start, stop or change. We'll start by describing wh

Interactive Ads - Google one-ups Yahoo again

Google's ( GOOG ) press release describing the expansion of a beta program for what are being called Gadget Ads has again shown that Google is unparalleled at melding technology and advertising to benefit its bottom line. Gadget Ads are mini-web pages or "widgets" that can be embedded within publisher pages. I have written in the past on Yahoo's ( YHOO ) Smart Ads and how, by more precisely targeting site users and adjusting ad content accordingly, they provide a much desired evolution of the banner or display ad format. Though Smart Ads and Gadget Ads are not really the same, I think it is fair to say that Google has seen the challenge of Smart Ads and has chosen to leapfrog Yahoo by rolling out its own update to the display ad format. The evolution of the Gadget Ad -- One of the trends on the Internet over the last year or so involves software developers creating "widgets" which can be hosted within web pages and blogs. Widgets can be pretty much any