Short and leveraged ETFs are one of the most powerful and misunderstood tool available to investors. Just like a power tool, short and leveraged ETFs can cause a lot of damage and do a lot of good. Here’s how to use them correctly.
Short ETFs have been the best performing asset class ever since the market meltdown started in October 2007. Many short ETFs gained 100% or more and singlehandedly transformed a disastrous market into a profitable one.
Nevertheless, there are pitfalls investors need to be aware of. Otherwise unwanted side effects could leave you with all the sizzle and none of the steak.
Short ETFs intend to replicate 1x, 2x or 3x the daily inverse performance of the underlying index. Leveraged (long) ETFs intend to deliver 2x or 3x the daily performance of the underlying index. The leveraged component magnifies the performance of the underlying index while the short component delivers the opposite or inverse performance of the index.
Example: (leveraged) short ETFs
To illustrate, let’s take a look at a suite of short or inverse ETFs linked to the S&P 500 Index (NYSEArca: SPY). The Short S&P 500 ProShares (NYSEArca: SH) aim to deliver the opposite daily performance of the S&P 500, the UltraShort S&P 500 ProShares (NYSEArca: SDS) aim to deliver twice the opposite daily performance of the S&P 500 while the Direxion Large Cap Bear 3x Shares (NYSEArca: BGZ) aim to deliver triple the opposite daily performance. A 1% loss in the S&P 500 would (ideally) translate into a 1% gain for SH, a 2% gain for SDS and a 3% gain for BGZ.
Example: leveraged (long) ETFs
On the flipside, the objective of the Ultra S&P ProShares (NYSEArca: SSO) is to deliver 2x the performance of the S&P 500 while the Direxion Large Cap Bull 3x Shares (NYSEArca: BGU) aim to deliver 3x the performance of large cap stocks as represented by the Russell 1000 Index (NYSEArca: IWB), there is no triple leveraged long ETF linked to the S&P 500.
Full Story: http://www.etfguide.com/research/156/8/3-Pitfalls-Of-Leveraged-And-Short-ETFs/