risk of short puts on leveraged etfs

Discussion in 'Options' started by muthiahmerchant, Jan 13, 2010.

  1. I have been selling puts and calls on FAS picking strike price of 50 and 100 when they were at 75. Do anyone see any risks in them compared to stocks.

    I understand that the movement is going to be 3 times, but if a etf shutdown or something of that sort happens. On CNBC fast money, the folks were talking about never to sell puts on leveraged etfs, just wondering if there were other risks of leverage etfs.

    Thanks
     
  2. rew

    rew

    Well, I learned the hard way not to sell puts on leveraged ETFs (I lost $6000 the first time I did that and will never do it again.)

    The thing to keep in mind about leveraged ETFs is that once they go down they stay down. Example: Suppose the unleveraged ETF has a price action like this:

    100 -> 60 -> 100

    (Lose 40%, gain 66.6%, break even overall.)

    A 2x version of the same ETF looks like this:

    100 -> 20 -> 46.66

    (Lose 80%, gain 133.3%, you're still down by over 50%.)

    For this reason leveraged funds also make terrible long term holds. They're best used for short term trades when there's a clear trend. OTOH, if a 2x fund is clearly looking toppy it might make an excellent candidate for buying puts. After all, somebody made a bundle off of me.
     
  3. thanks for your comments. You bring up an excellant point about buying puts on them when they go down
     
  4. LOL thanks for the math lesson. But ur argument doesn't make any sense. Use your logic on the indexs... 14000 down 60% is 5600. Up 100% is 11200... Not back to even either... The reason the etf's don't "track" right is because of their daily re-balancing.

    The problem with the system above is that the volatility is huge. And could drop signigicantly and get you in big trouble.
     
  5. rew

    rew

    My math is correct. My point is that if the underlying ETF goes down and then recovers to its original price the 2x version of that ETF will not. If you don't understand this go ahead and trade those leveraged ETFs at your peril.
     
  6. johnnyc

    johnnyc

    supposed to be increased margin requirements on naked options on the leveraged etf's in the near future as well. requirements for the underlying's were already jacked up
     
  7. rew

    rew

    As a follow up to my claim about leveraged ETFs being a terrible long term hold, let's look at two cases, one theoretical and one real.

    Suppose we have an ETF with this price action:

    100 -> 105 -> 100 -> 95 -> 100 -> 105 -> 100 -> 95 -> 100 -> ...

    That it, it oscillates forever in a narrow band between 95 and 105.

    In terms of fractions, the multipliers are 21/20, 20/21, 19/20, 20/19.

    For the 2x ET, those multipliers become 11/10, 19/21, 9/10, 21/19.
    Multiply those together and you get 99/100. That is the 2x ETF loses 1% of its value per cycle. After 20 cycles, the ETF is exactly where it was originally and the 2x ETF is down 18.2%.

    Let's look at a real world example. Gold has been in a long term bull market, with plenty of ups and downs in between. Two years ago you could have bought GLD at 87.50. Today it's at 107.22, a 22% gain. Surely you would have done much better with DGP, the 2x Gold ETF? Well two years ago DGP was at 25.45. Today it's at 26.30, a 3% gain. If that's how well a 2x ETF does in a bull market, you can imagine how it does in a flat or bear market.

    The best bet with any 2x ETF is to short it after any run up.