Covered Calls and Leveraged ETFs – Know the Risks

 

Date: 6/3/2022
Author: Chris Hood

 


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The power of double and triple-leveraged ETFs is immense.

They can provide fantastic returns on solid setups.

For instance, if you’re bullish on SPY, you can trade SPXL. It tracks SPY’s movements at 3 times the rate for a fraction of the cost.

Keen to increase your exposure to energy-related equities?

Then consider GUSH instead of XOP or ERX rather than XLE. You’ll be more richly rewarded if you’re correct in your prediction.

These leveraged ETFs amplify moves in the underlying index.

It is possible to go short with these as well.

Tickers like SPXS, DRIP, and ERY move opposite the indexes they track. However, trading these is more complicated because of how the price is calculated.

Use those only for day-trading or short-term holds. NEVER invest in shares of these for the long-term holds

They aren’t made for that, and you will lose money.

Today we’ll focus exclusively on bullish ETFs.


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There are some leveraged bullish ETFs that I do accumulate on pullbacks because I can hold these as stand-ins for the indices they represent.

When a sector moves, I want to make the most of it.

For instance, during bull markets, I slowly build positions on SPXL to make the most of the regular upswings.

Similarly, even though SOXL has taken a beating over the past few months, the semiconductor sector will recover at some point. When I see signs of a reversal, I’ll likely start building a new position.

You can protect these assets from price volatility with options just as with other stock shares.

Long collars and married puts keep you safe when the stock pulls back, and if the trend is more or less flat, then covered calls help you bring in income.

Covered calls are usually one of the first strategies options traders learn because brokers consider them low-risk.

But leveraged ETFs pose a unique risk for this strategy.

So let me first refresh your memory on covered calls work.

I can sell long calls above the stock price and collect income when neutral to slightly bullish on stocks I own.

Should the stock price not exceed the strike of that call by expiration, I keep the premium.

So if I owned 100 shares of SOXL and it was trading at 30.00, I might sell the 35.00 call against them for next month’s expiration. If SOXL didn’t rise above 30.00 by the expiration date, I’d keep the money collected plus my shares.

If it were trading higher than my short call strike of 35.00, I’d lose the shares.

But I would keep the premium and profit of 5.00 per share on the price increase.

It’s called a covered call because I own the shares I’m selling the call against. This is pretty basic stuff so far – most of you probably already understand the strategy.

Here’s the problem.

Leveraged ETFs often undergo reverse stock splits. Direxion, Proshares, and other funds which issue many of these will sometimes declare reverse splits when bullish ETFs share prices fall too low.

The logic is sound.

Stocks must meet minimum requirements to prevent delisting or reducing available shares to prevent short-sellers from manipulating the price. The issuing companies are just managing their products to keep them tradable.

If you just hold the shares, there’s no problem.

On a 1:10 reverse split, your 100 shares of 5 dollars will just become 10 shares priced at 50.00 per share.

No actual financial loss there.

However, if you rely on those shares to cover a short call, you would need to purchase 90 more shares. Remember that one options contract represents 100 shares.

You’ll have to spend 450.00 more to buy those shares and maintain the position or close the short call early for a potential loss.

This might not be a big problem for those with lots of capital.

But if you have a smaller account, you could create an oversized position or take an unnecessary loss…neither is a great situation.

Despite the power of leveraged ETFs, they have nuances and risks different from other stocks.

Always know what you’re getting into before you trade.

Cheers,
Chris Hood

PS – For those of you who want to take a deeper dive into options trading, I invite you to come join our Alphahunters team. Let me be your personal coach and show you how to navigate the markets profitably. The opportunity for financial freedom is just a click away.


 

 

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