In this article I will look at the potential benefits of inverse and leveraged ETFs, however there are very significant risks as well that are not fully disclosed. You can learn more about that in our article on the risks and disadvantages of leveraged or inverse ETFs.
Aggressive investors will often use margin to increase their buying power and leverage. However, margin has significant downside risks as well. With recent product innovations, traders may want to use margin less and less. In this article and video we will look at what margin is and why some of the new products in the market may be better alternatives.
Margin increases your buying power. By using margin, it is possible to borrow half the cost of a stock from your broker. For example, if a stock costs $20 but you borrow half of that amount from your broker you have only invested $10 of your own money.
Video: Leveraged ETFs Part One
Because you have used margin if the stock moves to $25 you have made a 50% return on investment. If you had financed the entire purchase from the cash in your account you would have only made 25%. Margin can also be used by option traders to finance half the price of a long options contract. The potential benefits are similar to buying stock on margin but the risks are also the same.
Two of the most significant disadvantages of using margin are costs and increased risk. The amount of money you borrow from your broker has interest charges attached to it. I surveyed a few brokers today and saw margin rates that averaged approximately 6.5%. If that margin “loan” is held for long the interest charges can really eat into your profits. The increased risk of margin is the same as it is with all kinds of leverage. The increased buying power means that you could lose a larger percentage of your account if trades go against you compared to just using cash.
More traders are beginning to turn towards leveraged ETFs as an alternative to margin. These products trade like a stocks or standard ETFs but replicate the performance of using margin. This provides the benefits of margin without all the costs. The fees in these kinds of funds are higher than traditional ETFs but they are much lower than the interest due in a margin account. In the video I will contrast investing in a leveraged ETF that replicates the S&P 500 index with trading the SPY on margin.
In the previous section I looked at leveraged ETFs as a way to avoid the disadvantages of using margin. Leveraged ETFs also provide most of the same benefits of traditional ETFs.
Video: Leveraged ETFs Part Two
The most popular ETFs in the market today represent large pools of stock and are usually modeled after popular stock indexes. For example, in the last video I used the the SPY and SSO which are both modeled after the S&P 500 stock index but one is leveraged and one is not. There are ETFs and leveraged ETFs that follow Dow, Nasdaq and Russell indexes as well.
The advantage of using an ETF or leveraged ETF that represents a pool of stock or an index is that it is self diversified. Traders can reduce some of their market risk through diversification, which makes these ETFs very attractive. However these ETFs are still focused on stocks only and therefore if the entire market is falling the ETFs will also fall.
There are ways to increase the effectiveness of diversification by spreading your risk across other asset classes besides stocks. There are ETFs that represent the value and prices of assets like currencies, commodities and bonds that can help further improve your portfolio diversification.
For aggressive traders, it is possible to use leveraged ETFs to both diversify across asset classes as well as increases your buying power. In today’s video we will contrast two versions of non-stock gold ETFs in an un-leveraged and leveraged version. These are new products but are quickly giving more options to individual portfolio managers to manage risk and take advantage of opportunities.
Leveraged ETFs are a good alternative to using margin to increase your buying power but what if a bear market is in play and you don’t really want to increase your buying power? Traditionally, investors would start scouting for short positions to take advantage of the downside potential in the market but that comes with the disadvantages of margin again. A leveraged ETF may be a great solution in this situation.
Video: Leveraged ETFs Part Three
Shorting stock means that you borrow the stock from your broker and sell it for today’s price hoping to buy it back later and pay your broker back when the stock is at a much lower price. Selling high and buying low like this is one way to leverage a bear market. Typically, your broker will require you to leave half of the value of the stock you have shorted in your account in cash. They then “loan” you the remaining amount required for the stock that was shorted.
Shorting stock is a little complicated and the charges on the loan made by your broker increases trading costs. As an alternative there are leveraged ETFs that take care of the shorting for you. For example, in the video, I talked about the difference between the QQQ, which is a traditional ETF that follows the Nasdaq 100 index and QID a leveraged “short” ETF that replicates the returns from using margin to short the QQQ.
Because QID is the inverse of the QQQ it will rise in value as the bear market falls. This simplifies the process of taking advantage of a bear market and avoids the margin charges from your broker. Short ETFs like this are not just limited to stock indexes; you can find them for industry sectors, commodities and even currencies.