History teaches us to be careful in financial markets.
This is especially true for new products. That’s been the case since financial markets first opened.
In 1636, someone decided to sell futures contracts on tulip bulbs. That ended in the world’s first recorded market crash.
Then there were others.
Unit investment trusts contributed to the crash in 1929.
The 1987 crash was tied to portfolio insurance.
In the early 2000s, mortgages were sliced and diced into collateralized securities. That led to the 2008 crash.
There are more examples, but the lesson is clear: It’s important to be careful when new products are released.
But to survive the new American economy as it emerges with innovations, investors will need new investment tools.
Smart Tools for a New Economy
In 2006, ProShares brought leveraged exchange-traded funds (ETFs) to the market. These have been tested and are ready for smart investors to use.
Normally, an ETF buys shares of stock. If the basket of stocks moves up 1%, then the ETF gains 1%. If the basket falls, then the ETF falls an equal amount.
But these funds offer added leverage. They were designed to move two or three times as much as the underlying basket of stocks.
Because they use derivatives, leveraged funds also allow fund families to create inverse funds, which are designed to move against the underlying basket of stocks.
An inverse fund gains 1% when the underlying stocks fall 1%. And it delivers a loss when the stocks rise.
Leveraged and inverse funds create new possibilities for investors. But it’s important to understand that they also carry risks.
These funds are rebalanced daily. That means they only meet their objectives for one day. They do not track long-term trends in the market.
Therefore, many investors have suffered large losses by holding onto leveraged or inverse funds for too long.
These funds can also fall to zero. In 2018, a few leveraged funds collapsed when volatility increased in the market.
The Benefits of Leveraged ETFs
Despite the risks, leveraged ETFs are suitable for short-term traders. Returns can be large if the investor understands that these aren’t buy-and-hold investments.
The chart below helps explain why these types of funds are short-term tools.
Comparing DIA and 2 Leveraged ETFs
The black line shows the SPDR Dow Jones Industrial Average ETF Trust (NYSE: DIA).
The ProShares UltraPro Dow30 (NYSE: UDOW) is shown in green. UDOW moves in the same direction as DIA, but it seeks three times the daily gains of the Dow.
The red line represents the ProShares UltraPro Short Dow30 (NYSE: SDOW), which is designed to move three times as much as the Dow but in the opposite direction.
As you can see, the ETFs move as intended on a daily basis. But in the long run, the moves can be unpredictable.
SDOW delivered a large gain in the March 2020 market crash. But then it lost those gains in the recovery.
In the bull market, UDOW has gained more than four times as much as the Dow, revealing how unexpectedly good performance could just as easily have been unexpectedly bad.
The bottom line is that these ETFs are useful and can improve returns for short-term traders with a plan.
Recently, we’ve strengthened my One Trade service by providing the opportunity to trade leveraged ETFs along with the strategy.
Michael Carr, CMT, CFTe
Editor, One Trade