Options have a similar problem to futures contracts – you cannot hold your position until you are right.
Options have an expiry date. This means that if the market doesn’t move in your favor BEFORE a specified date, you will lose everything. And as I’ve already mentioned, nobody can always get their timing right. Sometimes you will be too early with your position. This unfortunately means that if the market’s temporary movement against your position lasts until the options expiry date, your options will expire worthless.
How leveraged ETFs solve this problem
Leveraged ETFs do not have the problem of “cannot hold your position until you are right”. This is because leveraged ETFs work differently than futures and options.
Leveraged ETFs are tied to an underlying market. For example, UPRO (3x leveraged S&P 500 ETF) is tied to the S&P 500. The only difference is that UPRO magnifies the S&P’s returns by 3x.
Leveraged ETFs multiple the DAILY change in the underlying market. This is different from futures and options, which magnify the underlying market’s returns from the day you open the position to the day you close the position.
Here’s a simple example.
Let’s assume that the underlying market went from $100 to $110 to $121 (essentially 10% increase per day).
A 3x leveraged ETF would increase 30% per day. It would go from $100 to $130 to $169. Meanwhile, owning a futures contract with 3x leverage (33.33% initial margin) would turn $100 to $163.
Notice how there’s a difference between $169 and $163. That’s the “compounding” that comes from leveraged ETFs.
The inverse means that while options and futures contracts can leave you penniless, you can never lose everything with a leveraged ETF. A leveraged ETF will never go to zero, and since there is no expiry date, you can afford to hold until you’re right.
If the market moves against your position in the short term, that’s ok! Just hold your position long enough until the market reverses in your favor. The leveraged ETF will lose money in the interim, but at least you won’t be forced to cut your position at the bottom of the market. You can just wait out your losses until it turns into a profit.
In essence, leveraged ETFs are better at protecting your downside than futures and options.
This article has been republished with permission from Modest Money.