There is much written about selecting an exchange-traded fund (ETF) or its leveraged counterpart. Often, much analysis is done on the actual components of the ETF and how it moves in conjunction with the style or sector from where it draws it holdings. Often, we talk about the age or maturity of the fund along with its liquidity. A new fund with low volume can be much more difficult and risky to play than an older fund with plenty of liquidity. This eliminates the risk of wide spreads or moving the market if trying to buy or sell a large position. However, I don't see much written about the availability of an options market when selecting an ETF or leveraged ETF. I find this especially important with leveraged ETFs. I want options. I hesitate to buy or short any leveraged ETF unless there is a liquid options market I can play around it.
Why are options so important? Well, I think it is always easier to understand relating when you relate it to something outside of the market to get a better feel. Imagine you had a timepiece. A watch. One of a kind. A true thing of beauty. Over time, it fluctuated in value, but you felt confident the value would increase over time. Unfortunately, as much as you like to wear the watch and show it off, there is no way to fix it. If it breaks, there are no replacement parts. If something happens to it, you are stuck with a piece that may only be right two times a day or worse, maybe you can't even read the dials any longer. It certainly wouldn't have the same value it did when it worked. You would be afraid to wear it anywhere or even take it out of the safe you kept it in.
Now imagine you have this very same watch, but there are ways to fix it if something happens to it. In fact, there are multiple ways to fix it, at different places for different costs. The cost often will depend upon how you want it fixed. Sure, the value will likely decrease when it breaks, but what if by fixing it, the value would be recovered over time. Most things, once broken, are never worth as much as they were when they were new and perfect. But not with this watch. It would be worth just as much, maybe even more, than before. I'd prefer that watch any day.
In trading, leveraged ETFs with options available are the fixable watch. If the position moves against you, a trader has the opportunity to employ a protection or a repair strategy. Think of it as insurance on the watch or even a warranty. Often repair strategies can be implemented with little or no cost. It is true these types of repairs may limit the upside, but the focus is on limiting further damage or recovering the lost value as quickly and as prudently as possible.
Leveraged ETFs which don't have an options market can be traded; however, I find a trader has a discernible advantage when the leveraged ETF carries a liquid options market. If not, at least look for a leveraged ETF whose underlying sector or style ETF has a very liquid options market, so some more advanced repair strategies can be considered. If not, you better be very careful with that watch, because if it breaks...
Timothy Collins has worked as a financial adviser since 1999, focusing on portfolio customization, with a concentration on correlation arbitrage and risk-managed growth. He started Collins Capital Advisors in 2007, which has evolved into TangleTrade Management, LLC. TangleTrade is an RIA firm dedicated to formulating customized risk-managed investment strategies for individuals and small businesses. TangleTrade Management now manages the TangleTrade Fund, a correlation arbitrage hedge fund utilizing the trademarked InterETF strategy.
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