Summary of Options on Leveraged ETFs: How Investors Actually Use Them

Author: Koen Hoorelbeke, Investment and Options Strategist

The article discusses the intricacies of leveraged ETFs (Exchange-Traded Funds) and how options can be utilized to manage risks associated with these financial instruments. Leveraged ETFs are designed to deliver a multiple of a single day's return, making them unsuitable for long-term holding due to the phenomenon known as volatility decay.

Key Points

1. Nature of Leveraged ETFs

Leveraged ETFs aim to amplify returns based on daily performance, not over extended periods. For instance, if an index falls by 10% one day and rises by 10% the next, a 3x leveraged ETF will not return to its original value due to the compounding effect of daily resets. This can lead to significant divergence from the underlying index over time, especially in volatile markets.

2. Hedging with Options

Investors can use options to hedge their broader positions without liquidating their holdings. For example, purchasing put options on a leveraged ETF can provide downside protection for a portfolio of stocks tied to a volatile sector, such as semiconductors. This method is often more capital-efficient than hedging individual stocks directly.

3. Mechanics of Options

When selecting options, investors should consider:

• Strike Price: Closer to the money options are more expensive but provide quicker loss offset.
• Expiry: Aligning the expiry with the actual exposure duration is crucial.
• Size: Using delta-adjusted notional rather than just premium budget for sizing positions.

4. Other Uses of Options on Leveraged ETFs

Besides hedging, options can be used to:

• Define a holding period explicitly.
• Access markets that may be closed to direct investment in the ETF.
• Gain exposure to amplified moves without full ownership of the ETF.

5. Common Leveraged ETFs with Listed Options

The article lists several popular leveraged ETFs, including:

• SOXL - 3x daily exposure to the semiconductor sector.
• UPRO - 3x daily exposure to the S&P 500.
• TNA - 3x daily exposure to the Russell 2000 small-cap index.

6. Final Thoughts

The author concludes that while leveraged ETFs are not designed for long-term holding, options provide a structured way to engage with these volatile instruments. They allow investors to define risk and manage exposure more effectively, although the inherent risks of volatility decay remain.

The article emphasizes the importance of understanding the mechanics of leveraged ETFs and options before engaging in trading strategies, highlighting the need for careful consideration of individual financial situations and risk tolerances.