Investors: Use Inverse and Leveraged ETFs To Boost Returns In Volatile Markets (SH, SSO, SDS, TNA, TZA)
Rick Pendergraft: The past year’s market has been a tough one for long-term investors. We saw the S&P 500 locked in a trading range from mid-November through mid-July with 1,250 serving as the low and 1,350 as the top.
This range subsequently gave way as the index dropped sharply during a three week period from July 22 through August 9, only to get stuck in another trading range. This one lasted from August 9 to October 21, with 1,100 serving as the low and 1,225 as the top.
What should long-term investors do during a period like this where trading ranges, not an extended trend, dominates? I suggest using inverse and leveraged ETFs.
Because of the choppiness of the market over the last year, the best way to benefit has been to play the swings. Now, you could use options in a time like this, but if you are not a fan of options, leveraged ETFs offer similar returns only without the time decay presented by options.
Before I get into how I use leveraged and inverse funds, an explanation of how these funds operate is in order.
Inverse funds are designed to move up when the underlying index moves down. These are bearish investment tools.
For instance, the S&P500 SPDR (NYSE:SPY) tracks the movement of the S&P 500 and it allows investors to experience the same returns as the index. The ProShares Short S&P500 Fund (NYSE:SH) is the inverse fund. If the S&P goes down one percent, the SH will go up approximately one percent.
Look at the chart below which tracks the SPY and the SH exchange traded funds over the last six months. The SH is the mirror image of the SPY. An investor that bought the SH would have done very well from April 29 through August 8. During this time, the SH gained almost 20 percent while the S&P lost 17.3 percent.
So how do I personally use inverse ETFs?
If I think we are due for a long-term correction based on the three analysis styles I follow – technical, fundamental, and sentiment – I will look to purchase an inverse ETF like the SH. In the ETF Master Portfolio I look to hold funds for a minimum of six months. If I am looking for a prolonged correction or bear market, I will recommend an inverse fund for the portfolio.
Buying an inverse ETF offers investors a chance to profit from a downturn in the market. They also offer an advantage over short selling as there aren’t any margin requirements or interest charges.
Over the last 10 years, the buy and hold philosophy has yielded next to nothing. In order to have made money in the market, you either had to move in and out or you had to be willing to make money on the bearish side. Inverse ETFs offer investors an easy way to profit from a downturn.
Another type of ETF investors can use are leveraged ETFs. Leveraged funds use derivatives to double or triple the movements of the underlying stocks. For example, the ProShares Ultra S&P500 (NYSE:SSO) is a double leveraged fund that is designed to move twice as much as the SPY.
Notice how I worded that last sentence, “designed to move”. Because these funds use options and other leveraged instruments the relationship doesn’t always maintain that perfect two-to-one ratio. In fact, my experience tells me that the longer the leveraged ETF is held, the less likely the coorelation is to be maintained and the more leverage applied, the more apt the relationship is to diverge.
Take a look at the chart of the SPY versus the SSO from March 2009 through March 2010. You’ll see that the SSO was up 181 percent while the SPY was up 72.7 percent. In this instance, the relationship broke down since the SSO was up way more than twice as much as the SPY. In this case it was to the SSO investors advantage. But trust me, that isn’t always the case.
If you look at this second chart from September 2008 through September 2009, the SPY only lost 9.74 percent while the SSO lost 34.62 percent. Clearly, the leverage instrument used and the duration of the holding impacts the two to one correlation.
Timing can be everything when you use leveraged ETFs. And you also have to remember that the leverage works in both directions. If you are wrong, you stand to lose twice as much – or three times, depending on which particlular levered ETF you buy. These investments are similar to options in that when you are right you stand to make a lot of money, and when you are wrong you can lose a lot.
With this in mind, I prefer to use the regular inverse funds when I have a long-term bearish outlook. If I am right and the market moves significantly lower, my return will be sufficient and I am making money when the market is falling.
If I have a short-term bearish outlook, I am more apt to use the leveraged inverse ETFs. In this scenario I am looking for a quick correction where I have definitive stop-loss points and definitive exit points to take gains.
Put it this way; I consider the inverse funds and the straight ETFs as investment tools.
The two and three times leveraged ETFs are trading tools.
The difference between investing and trading for me is the target time frame. Investors are in it for months or years whereas traders are in for hours or days.
But regardless of your strategy and your timeframe, there is an ETF that will suit your style and help boost your returns during a volatile market.
Related: Direxion Daily Small Cap Bull 3X Shares ETF (NYSE:TNA), Direxion Daily Small Cap Bear 3X Shares ETF (NYSE:TZA), ProShares UltraShort S&P500 (NYSE:SDS).
After a ten year career in banking, Rick Pendergraft chose to pursue a career in the arena of his true financial love- investing. Rick started his investment publishing career at Schaeffer’s Investment Research where he thrived in his new position and twice received the award for “Top Trader.” Rick continued his career at Agora Publishing starting the investment division Investor’s Daily Edge. At Agora he narrowed his focus specifically to Exchange Traded Funds. Since his days at Schaeffer, he saw the potential of ETFs and the massive growth in terms of offerings as well as interest from investors. The opportunities within the ETF world are endless.
Rick felt so strongly about ETFs that he launched PRO Investment Management which focuses on using ETFs to manage client portfolios. It’s objective is to protect and grow client investment portfolios by using a blend of equity and fixed income ETFs. The goal is to provide a steady growth rate while trying to avoid big setbacks like we saw in the overall market from 2000-2002 and again in 2007-2009. This same investment philosophy is applied to the ETF Master Portfolio. Proper diversification, proper asset allocation and winning by not losing are the cornerstones of Rick’s approach to the market.
Rick has developed a loyal following of readers who are grateful for his timely warnings and profitable advice. He is widely recognized as a market expert and has been frequently quoted by Reuters, BusinessWeek, Forbes, USA Today, the New York Times, and the Washington Post. He has also been interviewed on CNBC, Bloomberg and Fox Business News.