# How do leveraged etfs work

Everyday Finance

Shorting Leveraged ETFs to Profit in Any Market

Apr. 6, 2011 8:17 AM

Shorting leveraged ETFs may well be the Holy Grail of retail investing. Very few other opportunities exist for the routine retail investor whereby one can achieve gains in any market on virtual autopilot. While complaints, SEC investigations and over-regulation of leveraged ETFs abound due to their corrosive properties and the perpetual misunderstanding by retail investors, it's painfully obvious that by shorting these instruments of mass destruction you can add a profitable asset class to your portfolio. Various strategies exist and I'll cover a few here. But like everything in life, there's no free ride. And as I find with writing about unorthodox strategies sometimes, there will be misinterpretations and claims to the contrary. So, I'll do my best to highlight the risks, the benefits and the *facts* - historical returns and mathematical calculations.

**Why Shorting Leveraged ETFs is Profitable**

First, let's start by discussing why one would want to short leveraged ETFs.

**Leveraged ETFs are Train Wrecks** - Given enough time, they all go to zero unless a trend continues unbroken forever - which is not likely. To understand why this happens, you must first understand the dynamics of daily resets. Since the price of the leveraged ETF depends on the DAILY return on it's benchmark, over time, in a flat, or a moderately up/down/volatile market, it is a mathematical certainty that the share price will gradually dwindle. Take the following example of just holding a broad market index like (NYSEARCA:SPY ) S&P500 versus a leveraged ETF ProShares UltraPro S&P500 Bull 3x ETF (NYSEARCA:UPRO ). Let's look at the following hypothetical market returns of the underlying versus UPRO. I'll intentionally have SPY end with a flat total return and you'll see why UPRO declined in value:

*click to enlarge*

Note how after just 10 trading sessions, the leveraged ETF has already lost over 1% in what is a completely flat market. That example was hypothetical with fake prices and returns. **Want to see for real?**

Check out this chart of the same ETFs over a 6 month period (May 3,2010 - Nov 2, 2010) where SPY was virtually flat. SPY gained 0.6% while UPRO lost 3.4%. This is a small demonstration of how the leveraged can diverge from the underlying - so let's take it further.

Now, that may not sound that impressive, but check out what happened to financials during the volatility of 2008-2009. Over a 1 year period (Nov 14, 2008- Nov 13, 2009), while the underlying 1X Financials ETF (NYSEARCA:XLF ) was slightly UP from Nov '08-Nov '09, the 2X Financials ETF (NYSEARCA:UYG ) lost a third of its value.

You can go into Google Finance and plot and play various ETFs against each other all day and the results are somewhat mixed, depending on what the underlying market was doing. When flat, over a long period of time, the leveraged ETF proxy generally loses money. This is often true of moderately up or down markets, especially if there was a lot of volatility along the way. Where this works against you is when a market has a sustained trend that doesn't break - more on that below.

Note that 3X ETFs tend to provide even greater volatility given the additional magnitude over their 2X brethren, but you can't always find a 3X for each given asset class.

**Which Strategies to Short Leveraged ETFs**

There are numerous strategies you could employ to benefit from the value decay that leveraged ETFs experience. I'll lay out some pros and cons for each:

**Short Leveraged ETF Pairs?**

This is a method for those concerned about which direction the market's going to move. If you shorted virtually any asset class a few months back with the long-only ETF, you'd be in some pain right now. However, by shorting leveraged ETFs in pairs, you can often benefit from the value decay on both sides while remaining virtually market-neutral. This has been my primary strategy to date. The ideal situation here is that a market is roughly flat and you've made money on both sides of the trade, which is common.

**Short Short-Only Leveraged ETFs?**

OK, that sounds redundant. So, if you take an "inverse" or short equity index leveraged ETF and short it, the logic goes that since the general trend of the market is UP over time, then doing essentially a double short (with the added boost from shorting leveraged decay) would be a winner. Some commentors on my prior posts point to recent market performance as how this is a great strategy. Virtually every asset class has skyrocketed since the pivot bottom in March 2009. But that's the problem! Part of the beauty of a strategy to me is a hedged or market-neutral performance, whereas this is essentially overlaying risk on top of risk. If the market tanks, not only will your long portion of your portfolio tank, but your short inverse positions would go way negative as well, even more so than your conventional 1X holdings. So, this might work nicely if perhaps you're not in equities at all and want some alpha if the market rises. But personally, I like a paired long/short strategy.

**Short Range-Bound Leveraged ETFs?**

For someone who fears the unbroken trend problem that wipes out gains on shorting leveraged ETFs, it would be beneficial to hold a position in a range-bound asset class. One might consider say, certain currencies or Treasury ETFs to be somewhat range-bound. There's been some movement of late, but a 50% spike in an underlying currency or Treasury ETF would be highly unlikely, right? Well, I used to think metals were somewhat range bound and justified a pairs trade with this logic though. Read my warning below.

**Warning - Runaway Train!**

Here's where I'm going to douse your dreams of instant riches with some cold water. The absolute worst thing that can happen when shorting a leveraged ETF is when the trade moves against you - quickly. And it could get worse from there when your broker closes out your position because there aren't enough shares to borrow in the market or you've breached your margin limits.

Again, I want to reiterate that I've felt some pain personally in the world of shorting leveraged ETFs. When I started looking for candidates to short inverse pairs, I had felt metals might be good since they had been pretty volatile, the shares were available and I envisioned they might be range-bound for some time. After all, when it looked like the Financial world would collapse and it didn't, shouldn't that have spelled the end of the gold/silver hysteria? It didn't. While there's recently been easy money to be made in gold and silver pairs trades. I've been crushed by a silver leveraged short position. When I dual shorted the 2X Long Silver (NYSEARCA:AGQ ) simultaneous with 2X Short Silver (NYSEARCA:ZSL ), I realized close to a 90% gain on the complete value collapse of ZSL, BUT. I went way in the red overall because AGQ has lost me over 300%. This is because silver prices have spiked to incredible levels in unprecedented fashion and without that break in the trend that is so desired. Silver has pretty much just kept moving.

What did I do? Rather than just sit there and see my net losses pile up daily, I finally bought back some of the shares and also played an overlayed options position using a 1X silver proxy ETF (NYSEARCA:SLV ). The way I set it up, if silver kept running, the options would increase in value thus offsetting further losses in AGQ. Meanwhile, if silver declined, while I'd lose on the options, the gains on AGQ coming back in the right direction would be fierce. It's not an optimal solution since I was incurring commissions and it's tough to strike the right balance. But it helped me sleep at night and cash in on some options gains along the way.

The key

is, you've got to manage the portfolio, keep and eye on it and keep it from getting out of hand. From personal experience, I'm finding that the majority of my short leveraged ETF pairs are net winners, but a minority start to eat away to gains from the entire short cohort. My lesson learned is to diversify further, act more quickly and develop mitigating strategies like the options overlay earlier on. It's a continual learning process, one that I'm refining, until I finally land the coveted Holy Grail.

There are risks to be sure. Read this, study the charts, understand your downside risk before even considering shorting leveraged ETFs. But once you've undertaken the proper due diligence, it might be a nice supplement to your portfolio.

**List of Leveraged ETFs**

For your reference, I've included a listing of dozens of leveraged ETFs. Since there are new launches monthly, I may have missed a few, but surely within this list, you'll spot some candidates for consideration:

**All 2X ETFs by Ticker:**

AGQ Proshares Ultra Silver Bull 2x ETF

BIB Proshares Ultra Nasdaq Biotechnology Bull 2x ETF

BIS Proshares Ultra Nasdaq Biotechnology Bear 2x ETF

BRIL Direxion Daily BRIC Bull 2x ETF

BRIS Direxion Daily BRIC Bear 2x ETF

BZQ Proshares Ultra MSCI Brazil Bear 2x ETF

CMD Proshares Ultra DJ-UBS Commodity Bear 2x ETF

DDM Proshares Ultra Dow 30 Bull 2x ETF

DIG Proshares Ultra Oil & Gas Bull 2x ETF

DUG Proshares Ultra Oil & Gas Bear 2x ETF

DUST Direxion Daily Gold Miners Bear 2x ETF

DXD Proshares Ultra Dow 30 Bear 2x ETF

EET Proshares Ultra MSCI Emerging Markets Bull 2x ETF

EEV Proshares Ultra MSCI Emerging Markets Bear 2x ETF

EFO Proshares Ultra MSCI EAFE Bull 2x ETF

EFU Proshares Ultra MSCI EAFE Bear 2x ETF

EPV Proshares Ultra MSCI Europe Bear 2x ETF

EUO Proshares Ultra Euro Bear 2x ETF

EWV Proshares Ultra MSCI Japan Bear 2x ETF

EZJ Proshares Ultra MSCI Japan Bull 2x ETF

FOL FactorShares 2x Oil Bull/S&P500 Bear ETF

FSA FactorShares 2x T-Bond Bull/S&P500 Bear ETF

FSE FactorShares 2x S&P500 Bull/T-Bond Bear ETF

FSG FactorShares 2x Gold Bull/S&P500 Bear ETF

FSU FactorShares 2x S&P500 Bull/USD Bear ETF

FXP Proshares Ultra FTSE/Xinhua China 25 Bear 2x ETF

GLL Proshares Ultra Gold Bear 2x ETF

INDL Direxion Daily India Bull 2x ETF

INDZ Direxion Daily India Bear 2x ETF

JPX Proshares Ultra MSCI Pacific (ex-Japan) Bear 2x ETF

KRS Proshares Ultra KBW Regional Banking Bear 2x ETF

KRU Proshares Ultra KBW Regional Banking Bull 2x ETF

LTL Proshares Ultra Telecommunications Bull 2x ETF

MVV Proshares Ultra MidCap 400 Bull 2x ETF

MZZ Proshares Ultra MidCap 400 Bear 2x ETF

NUGT Direxion Daily Gold Miners Bull 2x ETF

PST Proshares Ultra 7-10 Year Treasury Bear 2x ETF

QID Proshares Ultra QQQ (Nasdaq-100) Bear 2x ETF

QLD Proshares Ultra QQQ (Nasdaq-100) Bull 2x ETF

RETL Direxion Daily Retail Bull 2x ETF

RETS Direxion Daily Retail Bear 2x ETF

REW Proshares Ultra Technology Bear 2x ETF

ROM Proshares Ultra Technology Bull 2x ETF

RXD Proshares Ultra Healthcare Bear 2x ETF

RXL Proshares Ultra Healthcare Bull 2x ETF

SAA Proshares Ultra SmallCap 600 2x ETF

SCC Proshares Ultra Consumer Services Bear 2x ETF

SCO Proshares Ultra DJ-UBS Crude Oil Bear 2x ETF

SDD Proshares Ultra SmallCap 600 2x ETF

SDK Proshares Ultra Russell MidCap Growth Bear 2x ETF

SDP Proshares Ultra Utilities Bear 2x ETF

SDS Proshares Ultra S&P 500 Bear 2x ETF

SFK Proshares Ultra Russell 1000 Growth Bear 2x ETF

SIJ Proshares Ultra Industrials Bear 2x ETF

SJF Proshares Ultra Russell 1000 Value Bear 2x ETF

SJH Proshares Ultra Russell 2000 Value Bear 2x ETF

SJL Proshares Ultra Russell MidCap Value Bear 2x ETF

SKF Proshares Ultra Financials Bear 2x ETF

SKK Proshares Ultra Russell 2000 Growth Bear 2x ETF

SMK Proshares Ultra MSCI Mexico Bear 2x ETF

SMN Proshares Ultra Basic Materials Bear 2x ETF

SRS Proshares Ultra Real Estate Bear 2x ETF

SSG Proshares Ultra Semiconductors Bear 2x ETF

SSO Proshares Ultra S&P 500 Bull 2x ETF

SZK Proshares Ultra Consumer Goods Bear 2x ETF

TBT Proshares Ultra 20+ Year Treasury Bear 2x ETF

TLL Proshares Ultra Telecommunications Bear 2x ETF

TPS Proshares Ultra Bear 2x TIPS ETF

TVIX Velocity Shares 2x Short-Term ETN

TVIZ Velocity Shares 2x Medium-Term ETN

TWM Proshares Ultra Russell 2000 Bear 2x ETF

TWQ Proshares Ultra Russell 3000 Bear 2x ETF

UBR Proshares Ultra MSCI Brazil Bull 2x ETF

UBT Proshares Ultra 20+ Year Treasury Bull 2x ETF

UCC Proshares Ultra Consumer Services Bull 2x ETF

UCD Proshares Ultra DJ-UBS Commodity Bull 2x ETF

UCO Proshares Ultra DJ-UBS Crude Oil Bull 2x ETF

UGE Proshares Ultra Consumer Goods Bull 2x ETF

UGL Proshares Ultra Gold Bull 2x ETF

UKF Proshares Ultra Russell 1000 Growth Bull 2x ETF

UKK Proshares Ultra Russell 2000 Growth Bull 2x ETF

UKW Proshares Ultra Russell MidCap Growth Bull 2x ETF

ULE Proshares Ultra Euro Bull 2x ETF

UMX Proshares Ultra MSCI Mexico Bull 2x ETF

UPV Proshares Ultra MSCI Europe Bull 2x ETF

UPW Proshares Ultra Utilities Bull 2x ETF

URE Proshares Ultra Real Estate Bull 2x ETF

USD Proshares Ultra Semiconductors Bull 2x ETF

UST Proshares Ultra 7-10 Year Treasury Bull 2x ETF

UVG Proshares Ultra Russell 1000 Value Bull 2x ETF

UVT Proshares Ultra Russell 2000 Value Bull 2x ETF

UVU Proshares Ultra Russell MidCap Value Bull 2x ETF

UWC Proshares Ultra Russell 3000 Bull 2x ETF

UWM Proshares Ultra Russell 2000 Bull 2x ETF

UXI Proshares Ultra Industrials Bull 2x ETF

UXJ Proshares Ultra MSCI Pacific (ex-Japan) Bull 2x ETF

UYG Proshares Ultra Financials Bull 2x ETF

UYM Proshares Ultra Basic Materials Bull 2x ETF

XPP Proshares Ultra FTSE/Xinhua China 25 Bull 2x ETF

YCL Proshares Ultra Yen Bull 2x ETF

YCS Proshares Ultra Yen Bear 2x ETF

ZSL Proshares Ultra Silver Bear 2x ETF

**All 3X ETFs by Ticker:**

BGU Direxion Large Cap Bull 3x ETF

BGZ Direxion Large Cap Bear 3x ETF

CZI Direxion Daily China Bear 3x ETF

CZM Direxion Daily China Bull 3x ETF

DPK Direxion Developed Markets Bear 3x ETF

DRN Direxion Real Estate Bull 3x ETF

DRV Direxion Real Estate Bear 3x ETF

DZK Direxion Developed Markets Bull 3x ETF

EDC Direxion Emerging Markets Bull 3x ETF

EDZ Direxion Emerging Markets Bear 3x ETF

ERX Direxion Energy Bull 3x ETF

ERY Direxion Energy Bear 3x ETF

FAS Direxion Financials Bull 3x ETF

FAZ Direxion Financials Bear 3x ETF

FCGL Direxion Daily Natural Gas Rltd Bull 3x ETF

FCGS Direxion Daily Natural Gas Rltd Bear 3x ETF

LBJ Direxion Daily Latin America Bull 3x ETF

LBND PowerShares DB 25+ Year Treasury Bond Bull 3x ETF

LHB Direxion Daily Latin America Bear 3x ETF

MWJ Direxion Mid Cap Bull 3x ETF

MWN Direxion Mid Cap Bear 3x ETF

SBND PowerShares DB 25+ Year Treasury Bond Bear 3x ETF

SDOW Proshares UltraPro DJIA Bear 3x ETF

SMDD Proshares UltraPro S&P Midcap 400 Bear 3x ETF

SOXL Direxion Daily Semiconductor Bull 3x ETF

SOXS Direxion Daily Semiconductor Bear 3x ETF

SPXU ProShares UltraPro S&P500 Bear 3x ETF

SQQQ Proshares UltraPro Nasdaq-100 Bear 3x ETF

SRTY Proshares UltraPro Russell 2000 Bear 3x ETF

TMF Direxion 30 year Treasury Bull 3x ETF

TMV Direxion 30 year Treasury Bear 3x ETF

TNA Direxion Small Cap Bull 3x ETF

TQQQ Proshares UltraPro Nasdaq-100 Bull 3x ETF

Source: m.seekingalpha.com

Category: Forex

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