Tactical ETF Strategies to Zig When the Markets Zag | ETF Trends

As we consider the risks that the markets face today, investors can turn to tactical exchange traded fund strategies to help better manage risks in these challenging conditions.

In the recent webcast, Tactical Trading: How To Play The Field When The Markets Zig-Zag, Ed Egilinsky, head of alternatives at Direxion, argued that over the short term, traders can use leveraged and inverse ETFs for highly tactical trading and hedging strategies.

David Mazza, managing director and head of product at Direxion, noted that leveraged and inverse ETF marketplace is comprised of 33 ETFs with $65.3B in assets under management, covering different levels of exposures and broad equity market segments, sectors, industries, single countries, and even fixed income, and alternatives. The leveraged and inverse ETF landscape is also dominated by equity funds, but there are over 25 commodity products, 15 fixed income products, and almost 15 alternative products for whatever it is that traders are focused on.

Egilinsky explained that the leveraged and inverse ETF marketplace provides tactical tools to access many different market segments with differing magnitudes of leverage. The tools magnify the returns of their benchmark index daily. Bull funds seek 200%/300% of the daily performance of the benchmark index while bear funds seek 200%/300% of the inverse of the daily performance of the benchmark index. They are designed to allow investors to gain additional exposure without the need for full dollar-for-dollar investment. These strategies are largely comprised of a combination of equity baskets and derivatives — typically swaps or futures contracts.

However, Mazza warned that these tools are more complex, and potential investors should still keep in mind that daily rebalance mechanics result in a unique set of drivers of performance when leveraged and inverse ETFs are held for periods longer than one day, especially in more volatile market conditions. The magnitude of leverage and daily rebalance design leads to notably different behaviors and results across different holding periods and market regimes.

“It is important to note that these leveraged and inverse ETFs are designed to track its underlying index by its specified leverage point for any given single day. When holding these for more than one day, an investor should be aware of the potential compounding impact,” Mazaa said.

“When you get periods where the underlying index that the 3x ETF is tracking (as in this case) is volatile but with no clear direction, it is feasible the returns of both the 3x bull and bear will have a negative compounding impact​,” he added.

While these strategies can generate high returns during a strong rebound, they may also amplify losses if the markets swiftly turn. Consequently, potential users must consider the trend, as well as volatility, when utilizing leveraged and inverse ETFs, especially when the holding period is longer than one day.

“The point being with higher leverage products like 3x, the path dependency/direction of the underlying index is paramount to the impact it has on 3x returns over periods that are held longer than one day. This can result in either a negative or positive impact on return streams contingent on how the underlying index behaves,” Mazza said.

Mazza highlighted the Direxion Daily S&P 500® Bull 3X Shares ETF (SPXL), which experienced poor cumulative performance due to a lack of trend and increased volatility regime, but a more tactical approach with shorter holding periods (e.g. 10 days) resulted in better performance results.

“Different market and volatility regimes can lead to very different results across multiple holding periods for a 3X broad market ETF, but opportunistic traders can take advantage of the magnified exposure offered by L&I ETFs to potentially outperform,” Mazza said.

Mazza also added that traders that are familiar with different technical indicators, such as Bollinger Bands, MACD, relative strength index, and simple moving averages, can take advantage of leveraged and inverse ETFs to expand their toolkit for the implementation of their entries and/or exits.

For example, Joe Maas, CIO at Synergy Asset Management, argued that the MACD crossover is an indicator of a change in price momentum from negative to positive, or positive to negative. Traders who follow this indicator may like to be positioned long (or flat, or short) when buy or sell signals are confirmed.

“Leveraged and Inverse ETFs can be powerful tools in traders’ toolkits for implementation of these signals,” Maas said.

Among the most popular leveraged and inverse ETFs traded by value, the Direxion Daily Semiconductor Bull 3X ETF (SOXL), the Direxion Daily Semiconductor Bear 3X Shares (SOXS), the Direxion Daily S&P 500® Bull 3X Shares ETF (SPXL), and the Direxion Daily S&P 500 Bear 3x Shares (SPXS) are some of the most widely traded leveraged and inverse pairs that active traders have been utilizing to capture market swings.

Financial advisors who are interested in learning more about tactical strategies can watch the webcast here on demand.