Adding Leveraged ETFs To Your Trading Arsenal

Leveraged ETFs, which provide amplified exposure to different market indices, have given traders a powerful hedging or speculative trading instrument. The ETFs, however, can also be dangerous and should not be held for an extended period of time. These instruments usually provide two or three times exposure to a specific sector or index. The ProShares UltraShort QQQ ETF QID, for example, seeks daily investment results that correspond to twice the inverse (200%) of the daily performance of the Nasdaq 100. This ETF provides short-term traders with a hedging tool in fast markets.

A trader could purchase the QID on an intra-day basis in order to lay off exposure to the Nasdaq 100. The ETF could also be used as a speculative tool in order to express a short thesis on the broader stock market. It is important, however, not to hold leveraged ETFs for more than a few days because of the effect of decay. Since the instruments are based on the daily investment results of a particular sector or index, they exhibit decay over time.

For example, if a leveraged ETF fell 10% one day from $100 to $90 and then rose 10% the following day from $90 to $99 an investor who was long the ETF would have lost $1 to decay. Similarly, if the ETF jumps 10% on day one from $100 to $110 and then falls 10% the following day to $99 the investor has once again lost $1 to decay in a very short period of time. For this reason, these instruments can be disastrous to hold for an extended period of time in volatile markets that don't really go anywhere. Overall, leveraged ETFs make very poor investments, but can be useful in short-term trading and speculation.

Other popular instruments include the Direxion Financial Bull 3X FShares ETF FAS and the  Direxion Daily Financial Bear 3X Shares ETF FAZ. Traders will use these instruments to speculate on the direction of the financial index on an intra-day basis or hedge their exposure, either long or short, in financial stocks. As speculative trading tools, these ETFs generally do best during trending markets and extended moves.

Financial leveraged ETFs have been particularly popular in recent years as the mortgage collapse and then the European sovereign debt crisis roiled global markets. There are leveraged ETFs that track the performance of numerous tradable assets from commodities, Treasuries and foreign equity indexes to large-cap stocks, oil stocks and semiconductor stocks.

Although volume can be very thin in some leveraged ETFs, there are many others that are popular with day-traders and hedge funds and always have suitable daily trading volumes. Although these instruments have their drawbacks and can be risky, leveraged ETFs provide traders with another tool in their toolbox when navigating the markets.