Leveraged ETFs – Caveat Emptor

 

Date: 7/27/2021
Author: Chris Hood

 


Be sure to check out new episodes of my video podcast each week, where my ace pupil Brian Jones and I talk the ins and outs of options trading- and give you insights and strategy that you can immediately put to work for you in the markets.


The allure of trading options on leveraged ETFs is just too hard for many beginners to resist.

I’m here to tell you.

Resist the urge.

First of all, what is a leveraged ETF?

Many different leveraged financial products are designed to provide a two or three times return on their underlying index.

My track record of trading the triple leveraged tickers SOXL (semiconductors) and LABU (biotechnology) has been excellent. However, I don’t use options on these – I prefer the shares.

Here’s why.

Triple-leveraged ETFs are designed to provide a return that is 3x that of the underlying index.

For instance, SOXL seeks to provide a daily 3% increase in price for each 1% increase of the PHLX semiconductor index (SOX). The allure of high yield is what makes it attractive to traders.

This leverage makes it highly volatile. It can easily swing up or down by 30-50% in just a few days.

Day traders can take advantage of this for some potential massive returns.

The major problem with long-term options trading on these ETFs is how the share price is calculated. SOXL only provides the 3x leverage on a single day rather than on an annualized basis.

Any significant price drop can create a hole that’s nearly impossible to climb out of.

SOX trades currently at 3275.50, while SOXL is sitting at 41.33. Thus, there’s quite a significant price disparity, as is often the case between indexes and ETFs.

Instead of creating an exceptionally complicated math problem, let’s assume both traded at 100.00 to see how SOXL moves relative to SOX.

Assume SOX has a 1% gain over 2 days from 100.00 to 101.00. This would cause SOXL, at least in theory, to move 3% from 100.00 to 103.00.

On the upside, the leverage creates a much more powerful return.

Also, if we consider the actual price of the index versus the ETF, it’s much more affordable.

Likewise, if SOX moved down 1% to 99.00, we would see a drop in SOXL to 97.00.

Seems simple enough.

The problem is that the percentage moves on SOXL reset every day. So if SOX then moved back up 1% (from 99.00), it would reach 99.99.

On the other hand, SOX moving back up 3% from 97.00 would only get to 99.91.

Every dip downward drives the share price of SOXL further down.

Consider how much of a difference a 5% drop in SOX in one day would have in the value of SOXL. A 15% drop is massive.

That’s just with the shares of stock.

Options are already leveraged, and long-duration calls can be beaten into hopeless losers with any sustained downward price action.

I don’t want to get too technical with the options price fluctuations, but suffice it to say you wouldn’t want to be holding a SOXL during a hard pullback.

Even a series of moderate downswings in price will batter your long calls into submission.

My strategy with these stocks is to accumulate shares with profits from trading. So I look to buy these when they’ve bottomed out.

I don’t like to make market predictions, but I will here.

Semiconductors and biotech are not going to zero. And I can rely on the cyclicality of SOXL and LABU to let me buy low and sell high.

Never just throw trades on leveraged products you don’t understand.

Take the time and put in the research to know how these underlying shares are priced and how they move.

Maybe some of you will be profitable trading these as you advance. If so, then keep doing it.

Find out what works for you.

It’s the only sure path to becoming a successful trader.

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