If you have been watching investing TV commercials lately, you have probably seen the the popular ETF commercial. It starts with a guy daydreaming and suddenly finding himself taking a tour of his own mind. In here, he comes across several little mini-me versions of himself running around. When he asks someone who these people are, the tour guide tells him that these are his investment ideas. The guy then asks ‘Why are they so small?’. At this point, the guide points to a corner of the room to a giant version of himself – ‘Not all of them are. This one has been here for a while and we think you should let him out’. At this point the company name flashes across the screen.
This was definitely one of the more engaging ads related to investing. When I saw this advertisement, I thought this clearly showed the profit potential of the 2X leveraged Exchange Traded Funds that made Proshares famous. These funds return 2 times (also called 2X) the return of the underlying index. Its easier to understand through an example. Lets assume that you think the financials sector were going to suffer in the short-term you want to be shorting one of the indexes.
If you were very confident and wanted to take on more risk for a greater reward you would by the 2X inverse of the financials sector. So, if the index fell down 5% as you had anticipated and you had invested in the 2X leveraged short ETF your returns would be 10% (twice the return of the index). Before you start seeing dollar signs in front your face, you should also consider the reverse. If the sector were up 5%, your loss would be 10%. Thats what the leverage does for you, accelerates your profits and losses. There are 100+ funds available across a variety of sectors a few of the 2X leveraged type.
So, how do investors/traders profit from these ETFs? Two ways – Speculation and Hedging. Traders or speculators pick a long or short position depending on the direction the market sector is heading. If they are right they cash in their profits. Very rarely do traders hold leveraged positions for long periods of time due to risk of high losses and small window of opportunity. As far as the hedging strategy is concerned investors or money managers hold a smaller 2X leveraged position in the opposite direction of their main trade e.g. if the financials index were expected to move upwards, they would buy stocks of a few financial firms and buy a smaller position in the 2X ETF. The aim would be to offset any potential losses in case the market moves drastically against the financials.
Are 2X leveraged funds right for the novice investor? Most definitely not. These funds are best used by sophisticated investors with significant experience. Do your due diligence, only use these with tight trading stops so that your profits are locked in and potential losses are limited.
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