Pairs Trading with Leveraged ETFs
Leveraged ETFs are a widely traded, increasingly popular vehicle among active traders. The tremendous benefits that leveraged ETFs can offer traders who use a quantified strategy are diverse, while the different ways in which you can trade them every day are equally distinctive as well. Whether you’re looking to limit your portfolio risk, maximize the reach of your capital, or strive for exponential gains, leveraged ETFs can offer the informed trader a wealth of opportunity.
One way you can take advantage of leveraged ETFs is with a pairs trading strategy, something many of you are probably familiar with already from trading other vehicles. Holding two different positions in equities that closely correlate with each other in order to hedge your original position is a time-tested means of regulating risk in your portfolio, and it can protect you against the dramatic losses that can occur if the market moves against you when trading a highly leveraged ETF.
As the spread between your two ETFs revert back to their means, your profit in these trades will be realized. The increased exposure that leveraged ETFs offer traders is available without having to lay out the same amount of capitol it would take with another equity or security, and with a properly executed pairs trade they can be utilized to provide a broader and safer position in the market.
As I mentioned earlier, a leveraged ETF pairs trading strategy can minimize personal portfolio risk while still taking advantage of the potentially lucrative world of leveraged ETF trading. The broader techniques surrounding pairs trading and the correlations between two vehicles are just as relevant in trading leveraged ETFs like ProShares Ultra QQQ (QLD) and ProShares UltraShort QQQ (QID), or ProShares Ultra Oil & Gas (DIG) and ProShares UltraShort Oil & Gas (DUG).
Many traders might take advantage of the 2x leveraged ETF ProShares Ultra S&P500 (SSO) to obtain increased exposure to the S&P500, but those who also take a position in the inverse leveraged ETF ProShares UltraShort S&P500 (SDS) can hedge their primary position if the market doesn’t align with their prediction for market movement.
In looking at SSO and SDS we can see their close inverse correlation, and how you could take a long position in one and a short in another depending on market conditions to protect against unnecessary losses.
While you could hedge a position in a leveraged ETF with another unleveraged security or even with options, with an inverse ETF like SDS traders can hedge against the same amount of exposure, and all without having to lay out a larger amount of cash or dealing with looming expiration dates.
For short-term trading, there are few vehicles available to active traders currently that can offer as much potential for substantial gains as leveraged ETFs can. The propensity of leveraged ETFs to revert back to their mean within a week makes them all the more attractive to traders using a high-probability strategy on a daily basis. When combined with an informed pairs trading strategy, leveraged ETFs can provide serious opportunities.
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