Use Leveraged ETFs To Boost Your Investing Returns
I’m sick and tired of all bad press about leveraged ETFs. I’ll admit it. I’m mad.
It all came to a head last weekend when I met a friend for drinks. After discussing baseball and the upcoming football season (it can’t get here fast enough), our conversation eventually turned to the markets (as it often does).
Nathan asked, “What’s your take on leveraged ETFs, I’ve heard they’re a no win investment?”
He couldn’t have been more wrong. But I don’t blame him for his perception. It seems like the main stream financial media runs a story on problems with leveraged ETFs daily. I know the Wall Street Journal does! Despite their naysayers, I think they’re a great tool if you know how to use them. (I’ll tell you how I use them in a minute.)
I’m sure you’ve seen the arguments.
The main point of contention is investors didn’t (and apparently can’t) read the fund’s prospectus. The leveraged ETFs deliver 2 (200%) or 3 (300%) times the return of the underlying index each day.
Holding them for longer than one day can result in a tracking error with the underlying index. That’s just a way to say the ETF’s returns didn’t amount to 200% or 300% of the underlying index over time frames longer than one day.
Sometimes this can hurt an investor. But sometime it can help. However, you wouldn’t know it if all you did was read the main stream press.
Here’s a perfect example of a leveraged fund delivering greater than the 200% promised.
The Powershares QQQ ETF (QQQQ), better known as the Q’s, tracks the NASDAQ-100. So far in 2009, the Q’s are up 33%.
The leveraged ETF tracking the NASDAQ-100 is the Proshares Ultra QQQ (QLD). It’s up 69% in 2009.
And the story gets even better if you compare the two from the March low. The Q’s are up 56% and QLD is up a whopping 136%! Clearly the leveraged ETF is delivering more than 200%.
Leveraged ETFs magnify returns. It makes them an important part of my investment strategy. Here’s how I’ve had success using them.
I use a three step process to identify good opportunities to use a leveraged ETF.
I start off by looking at the overall trend of the market. Only use leveraged ETFs to trade in the same direction as the overall trend in the market.
For example, if the NASDAQ and S&P 500 are both in an uptrend, I’ll only use leveraged ETFs that go up when the market goes up. The opposite is true if the market is in a downtrend. I’ll only use short leveraged ETFs that go up when the market goes down. And if there isn’t a trend in the overall market, I don’t like to use leveraged ETFs.
Once the trend’s been determined, the next step is identifying a good entry point.
You can use any number of technical indicators to pin point a good entry point. I’ve had the best success buying pullbacks to support after a breakout above resistance. One support level I use is the 10-day moving average.
After you’ve identified an entry point and opened the position, always use a trailing stop.
The reasoning is simple. These are trades, not long term investments. Not every setup is going to work out as planned. You need a plan to lock in profits and to limit losses. It saves your trading capital in situations where your trade doesn’t go as planned.
The final step is to exit your trade. Don’t hold these leveraged ETFs forever. I’m normally out of the trade in less than a week.
One final piece of advice, when you’re trading, don’t make the mistake of falling in love with a certain investment. The market is always right. Be prepared to cut bait and move on if the market is telling you “you’re wrong”.
This process has produced more than its share of winners.
In the end, don’t let the naysayers and pessimists prevent you from making money. They’ll point to a few extreme examples as proof leveraged ETFs don’t work. We know better. Used correctly, they can be an extremely profitable way to increase your returns. You just need to make sure you understand what you’re buying and always have a plan.
Category: ETFs
