Ultra ETFs: Whether You’re Ultra-Long, Or Ultra-Short… Be Ultra-Careful

by Karim Rahemtulla, Options Expert
Tuesday, March 9, 2010: Issue #1212

If you’re looking for a simple, relatively safe, cost-effective way to diversify your portfolio, where’s your first stop?

Many investors choose the exchange traded fund (ETF) route. With the explosion of the ETF market over the past few years (there are now around 800 ETFs available), you can gain exposure to countries, sectors, industries, currencies and more. And you can do so in one single stock transaction through a regular brokerage account.

When you’re ultra-bullish, or ultra-bearish on the stock market, wouldn’t it make sense to take advantage by using “ultra ETFs?”

This class of ETFs aims to dish out two or three times the return of the underlying investment that they represent.

For example, if you think the market is heading to the moon, you can…

  • Buy a long-dated option on the S&P 500.
  • Buy the S&P 500 ETF itself.
  • Buy an ETF like the ProShares Ultra S&P 500 (NYSE: SSO), which offers twice the daily performance of the S&P. So if the S&P were to rise by 10%, you’d get a 20% move for the ETF. Simple, right?

Not so fast…

Read the Ultra ETFs Ultra Fine Print

With all the gains that ultra-long and ultra-short ETFs promise, I often get asked why I use long-dated options instead of these ETFs.

The answer lies in the fine print.

You see, these ultra ETFs aren’t designed for long-term investing. History shows that many of them actually lose money when the market rises over a period of several months. And when the market moves lower over the same period.

That’s because they reset on a daily basis… meaning you need a continuous sustained move in one direction to really make money.

For example, if the S&P were to move up by 3% in one week – uninterrupted – the ETF would perform as perceived. But any hiccup in that period and the ETF would head down.

So due to the daily reset feature, buying one of these ultra funds doesn’t automatically position you for big profits if the market moves in your favor. These funds were only created to take advantage of short-term market moves.

Here’s a better way…

Three Reasons to Pick LEAPS Over ETFs

A couple of weeks ago, a reader asked about the short trade I suggested on the euro in this article. He wanted to know why I recommended LEAPS (long-term options) and not the short euro ETF.

Simple. I’m looking for a longer-term decline, rather than just a short-term dip.

And in this case, a LEAP option is a much better way to go – for these three primary reasons…

  • It gives you the chance to benefit from a sustained move lower or higher.
  • It requires much less cash upfront, which provides greater leverage.
  • It gives you more time for the move to play out as you want it – up to three years in some cases.

Here’s a good example of how it works in reality…

Want “Ultra” Gains? How About 2,000% Potential?

A few months ago, I advised my 400 Report readers to buy LEAP options on US Airways (NYSE: LCC).

  • Specifically, we went for the January 2011 $7.50 calls.
  • We bought between $1.30 and $1.40 per contract when LCC shares were trading around $6.

Initially, LCC moved lower, taking our options down, too. But because we had time and little cash at risk, we were able to wait it out.

When the shares began to turn higher at the end of last year, we closed our LEAP position for gains of more than 60%. It put a “free trade” in motion – which could return us more than 2,000% by January 2011.

It’s something we wouldn’t have with an ETF of any type.

In short, there are many ways to play this market. But unless you’re a day trader, stay away from “ultra” ETFs that promise much more than they can ever deliver.

Instead, stick to strategies that allow you to bet on the market (or stocks) where the ground rules are crystal clear.

For more information, check out this report, which has all the details regarding the power of LEAPS – and my investing service dedicated to them, The 400 Report.

Good investing,

Karim Rahemtulla