From the February 01, 2011 issue of Futures Magazine • Subscribe!

Trading options on inverse and ultra ETFs

Question: How can traders take advantage of leveraged ETFs without a huge capital commitment?

Answer: Cut out the middleman and do as the indexers do, trade options on the ETFs.

Inverse and ultra exchange traded funds (ETFs) can be handy arrows to be found in a trader’s quiver. The "ultra" funds return two or three times the daily return than a normal ETF. Inverse ETFs can achieve the same goals as a straight out short position without consuming nearly as much margin.

What is an ultra ETF? It is an ETF that uses leverage. The 2X ultra aims to double the day’s return; the 3X ultra aims to triple the day’s return. A fund manager who is limited to having only 10% of his fund allocated to tech stocks could in effect double that exposure with a 2x fund. The ultras also save capital because double or triple the movement can be achieved with the same initial outlays. Leverage is a double-edged sword, however. If the ETF moves against the trader, more capital needs to be placed into the account. It is similar to a futures trade, but the ETF is trading the spot market and it does not have the same leverage as your typical futures contract.

Lehman Brothers ProShares offered the first ultra ETFs in 2006, with the introduction of its Ultra ProShares. For instance, ProShares Ultra QQQQ is an ETF that aims to double the performance of the NASDAQ 100 on a daily basis. So, if the QQQQ increases 1% on a particular day, QLD should be up around 2%. Smaller returns in a sideways market have a harder time achieving that same target. The ProShares have outlasted Lehman Brothers and have been sponsored by Barclay’s since Lehman’s demise.

The inverse ETF exists for the goal of profiting from a decline in the value of an index. Trading in an inverse ETF is the same as an outright short of the ETF. For instance, a trader could buy PSQ instead of shorting QQQQ. By purchasing shares in QID, a trader can get double the exposure to the downside.

Are these ETFs the best way to leverage your returns in either an up or down market? The creators of ultra and inverse ETFs use options to achieve their desired results. Traders can cut out the middleman by trading options on QQQQ themselves, rather than trading QLD, PSQ and QID.

Let’s say a trader has $56,000 to work with. The trader can buy 1,000 shares of QQQQ at $56. If QQQQ rises 1% in a day the trader will have $56,560 in his account at the end of the day. The trader could also by 651 shares of QLD, trading at $86, with the same amount of money. If QLD rises 2% the trader will have $57,120 at the end of the day (see "More bang for the $").

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Now, let’s say that a trader buys 100 at-the-money QQQQ Feb 56 calls for $1.20. That’s a total of $12,000 committed to the trade. QQQQ makes the same movement up to 56.56 as in the earlier example. The QQQQ Feb 56 calls rise to a value of $1.46. That’s an increase of $2,600, leaving the trader with $58,600 at the end of the day while the total downside risk is limited to the original $12,000 investment. The trader can cut down the risk even further by selling the QQQQ Feb 58 calls for 40¢, meaning the trader can buy the QQQQ Feb 56-58 call spread 100 times for 80¢. That’s an $8,000 capital commitment. A 1% rise in QQQQ would probably mean the spread would increase in value to 95¢, resulting in a profit of $1,500. The downside risk on the ultras is unlimited until it hits zero.

As far as inverse ETFs are concerned, buying PSQ is preferable to shorting QQQQ because only two-thirds of the capital is required. The trader can short 600 shares of QQQQ for $56, thereby committing $50,400 in capital. Purchasing 1,000 shares of PSQ at $33.60 will give an equivalent downside gain to the trader with a capital commitment of only $33,600. Let’s say that QQQQ declines 1% to $55.44 for a profit of $324. PSQ will appreciate 1% to $33.93 for a profit of $330.

The trader can buy 100 QQQQ Feb 65 puts for $1.20 with QQQQ trading at 56.00 for a capital commitment of $12,000. A 1% decline to 54.44 would result in the puts increasing in value to $1.44 for a profit of $2,400. The QQQQ Feb 54 puts could be sold for 60¢, thereby halving the capital commitment. The spread would widen from 60¢ to 74¢ for a profit of $1,400.

Inverse and ultra ETFs are nice trading tools, but are not nearly as effective as trading the options on the main ETF itself. While leverage is a double-edged sword, it is always better to have more control of your capital at risk.


Dan Keegan is an instructor with the Chicago School of Trading. Reach him at dan@thechicagoschooloftrading.com.

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