I’m sure you’re familiar with using exchange-traded funds (ETFs) to play sectors, countries and indices. However, you may not know as much about a subset of this asset called leveraged ETFs, which has become a phenomenal trading tool for savvy investors.
In a strong trending market, these instruments have performed amazingly well. The key to these profits has been the massive leverage that these securities have opened up to the general public.
Generally speaking, the typical stock buyer can only leverage his funds at a rate of 2-to-1 via margin buying. However, some leveraged ETFs can offer leverage of 3-to-1. And when purchased in a margin account, that leverage gets boosted to 6-to-1!
Outside of the options and futures markets, individual investors just haven’t had the opportunity to employ this kind of leverage before.
A Risky Bet
One problem with leveraged ETFs, however, is that they use futures and swaps to generate all of that leverage.
Price differences can emerge between different contract months on futures, which can lead to a wide departure between the performance of the leveraged ETF and the actual performance of the underlying securities supposedly represented by the ETF.
This is why, unless a strong trend is present, leveraged ETFs are better left as day trading tools rather than long-term strategic investments.
Many investors have found that out the hard way. Leverage is great when you’re right, but it burns through your equity at an alarming rate when you are wrong. Just like most things in the market, many, many people get it wrong when trading these instruments.
Handle With Care
This doesn’t mean that you can’t or shouldn’t use leveraged ETFs — just know that if you’re positioning yourself to make two to three times the returns, you also have to be ready for two to three times the losses if you’re not careful.
For example, with 2-to-1 leverage, every 1% move in the ETF translates into a 2% move for you — which is great if it’s in your favor, but potentially devastating if you didn’t use a tight stop-loss or if you bought on margin.
The investment message boards are replete with horror stories of investors blowing up their accounts with leveraged ETFs. Perhaps this is why the Financial Industry Regulatory Authority (FINRA) has recently imposed new margin requirements on these securities.
On Dec. 1, new rules went into effect that are a real blow for savvy investors who have been raking in the cash with leveraged ETFs. But I think we all knew that the free ride couldn’t last forever.
New Restrictions: Big Brother or Big Bother?
The long and the short of it is that FINRA is finally realizing that using margin to leverage an already highly leveraged product is probably not a good idea.
Some may say that FINRA is acting like a babysitter to the general public and that investors should be completely free to make their own moves. Anyone who’s been making money using these products will certainly feel that way. But for most investors, these new rules are actually going to save themselves from, well, themselves.
But don’t think for a second that FINRA is enacting these rules for your benefit.
Keeping Your Money — and Their Year-end Bonus — Safe
Like any casino operator, the big brokerage firms can’t have their customers losing money too quickly on just one game. Remember, Wall Street lives and breathes for commissions and capturing spreads. They need to keep you trading for as long as possible.
If they make you too much money, they fear that they will lose you. If they lose you too much money, they fear that they will lose you.
Their goal is to keep your trading account even for as long as they can. They always want you chasing for that elusive “high” of the next big winner. The longer they keep your money on deposit in their accounts, the more money they make. Accordingly, the longer you play the trading game, the more money they make.
If their sheep — oops … I mean customers — are getting slaughtered too quickly, it negatively impacts profits. And we can’t have that!
Paying More to Play the Leveraged ETF Way
So, while FINRA’s actions may be outwardly applauded by market watchdogs, don’t for a second think that any altruism is at play here.
The bottom line is that too many people were losing too much money too quickly in leveraged ETFs. It was souring an entire crop of new suckers — err … I mean investors — to stock-market trading.
The new maintenance margin requirements boost the minimum margin levels to as high as 90% minimum equity on 3-to-1 leveraged ETFs.
This will certainly save many investors from themselves, but it puts an end to a serious money train for the small cadre of savvy players who have been making a fortune from trading these instruments.
Get the full breakdown of the new margin rules.
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