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