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How to Trade Options on Leveraged ETFs

Before I start with how to trade Leveraged ETF options, let me remind you that I believe we are at the start of an etf creation bubble, in which retail investors are getting exposure to financial instruments that they don't need-- the capital base is not large enough to warrant that sort of exposure (Case Shiller ETF??). Also, many of these etfs have structural issues that cause them to consistently underperform the instrument they claim to track -- see USO and UNG for examples.

But there are some advantages with trading leveraged options. First, let's take a look at the downside:

  1. Leveraged ETFs go through a daily rebalancing, and that causes them to underperform over time just from their mathematical calculations. Unless there is a strong trend in price and volatlity, it is very difficult for these instruments to outperform in the intermediate term. The problem was so bad that Direxion did a reverse split in FAZ/FAS to encourage trading again.
  2. They encourage poor risk management as there is an extreme exposure to the underlying instrument. If the trader is not careful, more exposure can be gained than what is needed to generate a positive expectancy.

However, there are some features of L-ETF options that may provide value-- I'm speaking of FAZ/FAS in particular:

  1. The options are incredibly liquid. Daytraders and speculators provide a significant amount of volume throughout the trading day -- this is very nice to have when exiting out of a position, as liquidity is an essential part of risk management in trading options.
  2. The options trade in penny increments under 3 and 5 cent increments over 3. The strikes on the options are also a dollar wide. This adds to the liquidity.
  3. Selling options provides a positive theta, which can actually take advantage of the mathematical issues that the etfs provide.

Take for example this trade in FAZ. Assume that you wanted to gain some short exposure in the financials. Do note that this isn't a recommendation, although my subscribers are in something similar that expires this week.

So if we want to get some short exposure to financials, we could look to Sell the January 19 puts -- let's look at 5 contracts:

From this position we can see that our initial delta risk is 187 -- so that means we are effectively long 187 shares of FAZ, which means we are short about 560 shares... of what? Remember, FAZ/FAS track the Russell 1000 Financial Services Index. As far as I know, there is not a tradeable etf out there that we can use -- RIFIN tracks it but is not tradeable.

So we must assume that FAZ will track another etf on a percentage basis. The two that come to mind are XLF and IYF -- FAZ tracks IYF better as XLF has some insurance/real estate components in the name.

So to get the same exposure in XLF or IYF we would need to short 560 of XLF or IYF-- that would tie up a significant amount of capital -- 3k for XLF and 10k for IYF on an margined account. As you can see, the FAZ put sale only requires about 1500 in margin initially-- although that will increase if the trade goes against you.

So here are the advantages to this trade:

  1. Because of the liquidity, you can exit out quickly if you're wrong.
  2. Selling options provides positive theta, so you don't have to be right in a big way, the name can stay at the same price and you'll still make money
  3. You gain a significant amount of exposure for less capital -- that can free up money for you to do other trades (like hedging this position!)

The downsides, in my opinion, come down to the trader. If he/she sees this as an opportunity to load up in an account without respecting sound risk management parameters, it's going to hurt in the long run. On top of that, this trade makes the assumption that the implied volatility in the option is too high with respect on where we are headed in the near future. So if the financials catch a strong bid and the volatility picks up, this can be a losing situation. Given the current volatility environment, this trade has worked out quite well for the past 2 months, but it remains to be seen what January will bring.

Disclosure: My subscribers have something similar to this trade open in the model portfolio.

by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/