Read the prospectus on a given ETF. It shows you how the ETF is constructed, often by derivatives. Then, do the same thing.
Good point. However, for leveraged ETF's, this can't be done quite the same. UPRO (3x daily bull S&P 500) uses swaps with banks, which aren't generally available. Or at least I've never heard of how to get that for myself individually :/. http://www.proshares.com/funds/upro_daily_holdings.html
If there's an underlying you can trade you just rebalance your leverage everyday. Doesn't require reading one word of a prospectus.
For the people that don't understand what you are saying, how about showing us how, given what you are saying, you would rebalance SCO. Provide all the steps taken, including any research you did. Then, give an example of using one of your own leveraged ETFs.
True to my word I haven't looked at a single prospectus. Research: I saw SCO was a -2x leveraged etf so I looked for a -1x or +1x version of the same etf. I found a +2x but since this about replicating leveraged etfs in the first place I didn't consider it. I did not find a -1x or +1x version so I decided to use USO as my "underlying." I went and got 1 month price data for USO and SCO. Then rebalancing my USO deltas to -2x daily I got this equity chart. Blue is the performance of SCO, orange the performance of rebalanced USO. (This chart shows that the choice of USO as my +1x version was a good one.) Rebalance process in next post.
Rebalance process: It's just simple math. Hence my point of not needing to read a prospectus though it doesn't hurt. Let's use margin as our source of leverage. We want to replicate a -2x levered etf which means we want -2x the daily returns of the underlying. So what do we have? Day 1: Short $200 of USO for $100 in equity. Market falls 1%. Your $200 USO position rises to $204 dollars. Your equity rises to $104. But your leverage falls from 2:1 down to 204/104 = 1.96:1. You now need to sell an extra $4 of USO short. You now have $208 short of USO with $104 of equity, so back to a 2:1 leverage ratio and you are now good for Day 2. Repeat the process everyday or when your leverage deviates beyond some +/- level from 2:1. Interestingly, though the prospectus of any leveraged etf will tell you that a +2x leveraged etf will not track exactly double the performance of the underlying, using a similar rebalancing process you can extract an exact +2x performance of the underlying with +2x daily levered etfs. Edit: Fixed the numbers, forgot I was dealing with -2x leverage not -1x.
When you say you use margin as your source of leverage, you mean your margin account that you borrow from your broker right? I have only come across accounts where you can go to a 2:1 initial borrowing limit. Any idea how to go about replicating a +3x, +4x, or even +10x levered etf?
Reg T margin is limited to 2:1. Higher leverage with margin requires a portfolio margin account with a broker that provides portfolio margin. More than that there's nothing that says you can't do this with options which provide high leverage but that can get messy dealing with the Greeks.
Here is another way to think about leverage... Assuming the consensus opinion that oil is soon going to be worthless and that it will be distributed freely via community drinking fountains is wrong and you are interested in making a long term investment in Energy...lets take a look at a few options. You could invest $1000 in a popular fund like XLE and if it were to eventually one day recover to its highs you would realize an approximate $910 profit. You could instead invest $1000 in its 3X cousin ERX and if it were to one day recover to its highs you would realize an approximate $7800 profit. If you are feeling like the oil drinking fountain thesis has some merit and do not want to be too aggressive you could instead invest $116 in ERX and realize the same $910 profit that you would realize investing $1000 in XLE. Any thoughts?