How to Trade Leveraged ETFs

How to Trade Leveraged ETFs

Leveraged ETFs are an increasingly popular product among professional traders, many of whom hold positions in them every trading day. Simply put, leveraged ETFs magnify the returns of the index they are correlated with on a daily basis. They provide excellent exposure to the index or market sector you’re looking to have a position in, but are amplified by usually 2 or 3 times the normal 1:1 gain/loss ratio.

For traders who are looking to maximize the performance of their portfolio, leveraged ETFs provide excellent opportunities in both bull and bear markets when traded with a quantified high-probability trading strategy.

The Direxion Daily Financial Bull 3x Shares (FAS) leveraged ETF holds a 3:1 ratio of the daily performance of the Russell 1000 Financial Services Index. For every single dollar traders put into the fund, their money is matched with a further two dollars of invested debt. On a short-term basis, a 1% rise in the Russell 1000 Financial Index will correspond with a 3% rise of FAS. The opposite movement holds the same ratio as well, where if the Russell 1000 drops 1%, FAS can be expected to fall 3%.

Inverse leveraged ETFs like Direxion Daily Financial Bear 3x shares (FAZ) offer the same opportunities to traders but in the reverse movement of the underlying index, thereby offering you the trading positions to both take advantage of declining markets and hedge your other portfolio positions.

Since leveraged ETFs utilize futures and swaps to amplify their daily gains or losses, the funds themselves have their exposure reset after every trading day. Options, derivatives, and swaps are used to rebalance the leveraged ETF at the close in order to maintain the desired return of the vehicle.

When held for a longer period of time a leveraged ETF will erode in value and even veer away from the set return for the index. For this reason, we firmly believe in maintaining a short 5-7 day trading period on these leveraged ETFs. Another crucial feature of these vehicles is their tendency for mean-reversion in a short-term period. The same high-probability strategies professional traders use regularly with ETFs or stocks in respect to mean-reversion in many cases are applicable for trading with leveraged ETFs.

Let’s take a look at an inverse leveraged ETF tracking the Russell 1000 Energy Index – Direxion Daily Energy Bear 3x Shares (ERY) at the end of April 2012.

As Direxion Daily Energy Bear 3x Shares (ERY) became notably oversold, it opened an opportunity for traders to lock in on a profitable short-term downward trade.

The advantages of trading with popular high-volume leveraged ETFs like Direxion Daily Small Cap Bull 3X Shares (TNA), ProShares Ultra QQQ (QLD), ProShares Ultra Oil & Gas (DIG) and ProShares UltraShort Financials (SKF) are straightforward when considering the ability to spend less of your own personal money to secure a position reflecting your expectations for future market movement, without having to directly trade in other subsequent vehicles like futures or options.

While not suitable for long-term investment, and retaining the potential for significant losses in the leveraged ratio of capital, leveraged ETFs potentially offer you consistent results when executed with a high-probability strategy, even when the markets are volatile.

Larry Connors is CEO of Connors Research

Cesar Alvarez is Director of Research of Connors Research

Joshua Glasgall is Editor in Chief of Connors Research