This note is to share our tactical insights into the ETF and options markets. ETFs and options have unique risks and may not be suitable for all investors. Please consult with a qualified investment professional before investing in these instruments.
During our quarterly strategy call earlier today, we received questions about the use of leveraged ETF products.
We do not like leveraged ETFs for overnight positions. The structure which allows theses products to be created, by definition, limits the correlation to the underlying security, commodity or index to intraday moves. For investors who have an intermediate or long term directional conviction, and who wish to leverage their position, options on a non leveraged equivalent ETF or on the underlying index may be a viable alternative.
Some basics: purchasing an option limits the potential loss in the position to the price paid, selling an option without an offset in the underlying investment will expose an investor to a potential loss of either the entire underlying (selling a naked put) or an infinite amount (selling a naked call). In other words, if you haven’t used options before, read the educational literature on the CBOE’s website thoroughly and actually read the information your broker provides rather than just clicking “I accept” before you start trading. We would encourage you to make sure your broker actually understands how these instruments work – sadly, not all do – before you entrust your capital to their advice. I can’t stress this enough (I have spent the majority of my adult life trading derivatives and have as many gruesome stories about accidents as a career EMT).
The crux of this matter is that purchasing an option contract that is out-of-the-money (above the underlying price for calls, below the underlying price for puts) provides a significant amount of leverage and can pay off handsomely with a big movement in price. The value of one of these “lottery tickets” evaporates rapidly however as the time to expiration erodes or the underlying price moves in the wrong direction, presenting a great deal of risk. Purchasing an option that is near the current price or even actually “in-the-money” will provide a lower risk of erosion based on time or price action, but the absolute dollar cost will be more significant and the potential payoff profile will be more limited than that of an out-of-the-money contract if there is a big move in the underlying.
Options can be a useful investment tool (provided that you do your homework first) but they may not present the tactical flexibility a shorter term investment requires. For an investor looking to capture a directional movement of a few days to a week, a directional position in an unleveraged ETF may well provide more maneuverability than an option position, while providing true (if unleveraged) performance tracking the underlying.
The only time a leveraged product that resets daily makes sense is when it is being employed intraday. Your broker may not be able to explain this to you, because financial professionals are not required to be knowledgeable about ETFs, even if they invest their clients’ money in them. Now more than ever, buyer beware.