The Management

Originally Published in Futures Magazine

Question: How can traders take advantage of leveraged ETFs without a huge capital commitment?

Answer: Cut out the middleman and do as the indexers do, trade options on the ETFs.

Inverse and ultra exchange traded funds (ETFs) can be handy arrows to be found in a traders quiver. The “ultra” funds return two or three times the daily return than a normal ETF. Inverse ETFs can achieve the same goals as a straight out short position without consuming nearly as much margin.

What is an ultra ETF? It is an ETF that uses leverage. The 2X ultra aims to double the days return; the 3X ultra aims to triple the days return. A fund manager who is limited to having only 10% of his fund allocated to tech stocks could in effect double that exposure with a 2x fund. The ultras also save capital because double or triple the movement can be achieved with the same initial outlays. Leverage is a double-edged sword, however. If the ETF moves against the trader, more capital needs to be placed into the account. It is similar to a futures trade, but the ETF is trading the spot market and it does not have the same leverage as your typical futures contract.

Lehman Brothers ProShares offered the first ultra ETFs in 2006, with the introduction of its Ultra ProShares. For instance, ProShares Ultra QQQQ is an ETF that aims to double the performance of the NASDAQ 100 on a daily basis. So, if the QQQQ increases 1% on a particular day, QLD should be up around 2%. Smaller returns in a sideways market have a harder time achieving that same target. The ProShares have outlasted Lehman Brothers and have been sponsored by Barclays since Lehmans demise.

The inverse ETF exists for the goal of profiting from a decline in the value of an index. Trading in an inverse ETF is the same as an outright short of the ETF. For instance, a trader could buy PSQ instead of shorting QQQQ. By purchasing shares in QID, a trader can get double the exposure to the downside.

Are these ETFs the best way to leverage your returns in either an up or down market? The creators of ultra and inverse ETFs use options to achieve their desired results. Traders can cut out the middleman by trading options on QQQQ themselves, rather than trading QLD, PSQ and QID.

Lets say a trader has $56,000 to work with. The trader can buy 1,000 shares of QQQQ at $56. If QQQQ rises 1% in a day the trader will have $56,560 in his account at the end of the day. The trader could also by 651 shares of QLD, trading at $86, with the same amount of money. If QLD rises 2% the trader will have $57,120 at the end of the day (see “More bang for the $”).

By using options, a trader can make more efficient use of capital

Now, lets say that a trader buys 100 at-the-money QQQQ Feb 56 calls for $1.20. Thats a total of $12,000 committed to the trade. QQQQ makes the same movement up to 56.56 as in the earlier example. The QQQQ Feb 56 calls rise to a value of $1.46. Thats an increase of $2,600, leaving the trader with $58,600 at the end of the day while the total downside risk is limited to the original $12,000 investment. The trader can cut down the risk even further by selling the QQQQ Feb 58 calls for 40, meaning the trader can buy the QQQQ Feb 56-58 call spread 100 times for 80. Thats an $8,000 capital commitment. A 1% rise in QQQQ would probably mean the spread would increase in value to 95, resulting in a profit of $1,500. The downside risk on the ultras is unlimited until it hits zero.

As far as inverse ETFs are concerned, buying PSQ is preferable to shorting QQQQ because only two-thirds of the capital is required. The trader can short 600 shares of QQQQ for $56, thereby committing $50,400 in capital. Purchasing 1,000 shares of PSQ at $33.60 will give an equivalent downside gain to the trader with a capital commitment of only $33,600. Lets say that QQQQ declines 1% to $55.44 for a profit of $324. PSQ will appreciate 1% to $33.93 for a profit of $330.

The trader can buy 100 QQQQ Feb 65 puts for $1.20 with QQQQ trading at 56.00 for a capital commitment of $12,000. A 1% decline to 54.44 would result in the puts increasing in value to $1.44 for a profit of $2,400. The QQQQ Feb 54 puts could be sold for 60, thereby halving the capital commitment. The spread would widen from 60 to 74 for a profit of $1,400.

Inverse and ultra ETFs are nice trading tools, but are not nearly as effective as trading the options on the main ETF itself. While leverage is a double-edged sword, it is always better to have more control of your capital at risk.

Dan Keegan is an instructor with the Chicago School of Trading. Reach him at dan@thechicagoschooloftrading.com.

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Over 80 % of the time the relationship between the CBOE Volatility Index (CBOE: VIX) and the Standard & Poor’s 500 Index (SPX) is an inverse one. That close relationship does not mean that we can determine a particular price in the SPX by using a corresponding price in the VIX. Let’s compare the 2009 prices of the VIX to similar VIX prices in 2010, and how they correspond to prices in the SPDR S&P 500 ETF (NYSE: SPY), the exchange-traded fund that closely reflects the price of the SPX.

On April 15^th, 2009 VIX closed at 36.17 while SPY closed at 83.52. VIX historically trades around 10% of the value of the SPX, but there was a great deal of uncertainty – and therefore volatility – in last spring’s falling market. On April 27^th, 2009 the VIX closed at 38.82 while SPY closed at 84.10. On May 24^th, 2010 SPY closed at 107.20 while the VIX closed at the same 38.82 level from April 27^th, 2009. Different markets going in different directions but identical VIX levels. Here are some more examples:

On May 7^th, 2009 the VIX closed at 33.44 with SPY closing at 91.09. On June 8^th,2010 the VIX closed at 33.70 with SPY closing at 106.12.

On May 20^th the VIX closed at 29.03 while SPY closed at 88.67. On June 11^th, 2010 the VIX closed at 28.97 while SPY closed at 109.16.

On June 30^th, 2009 the VIX closed 26.35 while SPY closed at 90.59. On July 16^th, 2010 the VIX closed at 26.25 while SPY closed at 106.66.

On August 3^rd,2009 the VIX closed at 25.56 while SPY closed at 98.86. On July 21^st, 2010 the VIX closed at 25.64 while SPY closed at 107.07.

The price level for SPY is approximately 20% higher in 2010 than it was in 2009, but as you can see we have similar levels in the VIX. How much the investor benefits from VIX exposure is very volatile itself. Bullish portfolio definitely benefits with a positive VIX exposure, due to the inverse relationship between the VIX and the overall market. Normally there is more demand for options in a down market because the VIX can be looked at as a measure of the amount of time value that is embedded in SPX options.So why is the VIX so much higher, relatively speaking, than it was last year?

Part of it is probably the up and down nature of the market this year. Investors don’t seem to be trusting this year’s rallies. Fear has not been stamped out. If the market continues to rise at a steady rate the VIX will probably return to historically normal levels.

Wooden and Walton

Former UCLA Basketball Coach John Wooden passed away last Friday. There are many of you who are not old enough to remember a time when the NCAA Tournament was the UCLA Invitational. Between 1964 and 1975, UCLA won ten of twelve NCAA Tournaments. If freshmen could have played in 1966 it would have been 11 of twelve. And it took a great (and historically underrated) North Carolina State team 3 overtimes to stop a seven year run in 1974. A year later in Wooden’s final game he led his underdog Bruins over Kentucky for his tenth title.

Some would say that it helped to have recruits like Lew Alcindor (Kareem Jabbar), Bill Walton and many other All-Americans, but there are many teams like Michigan’s “Fab Five” of the 90′s and last year’s Kentucky team that have not won despite having the best recruiting class.

Many coaches talk of “building character” but take big money from shoe companies, recruit kids who can’t read, and will leave their school and their players for a big offer in a heartbeat. John Wooden was not like that. He was as different from John Calipiri or Rick Pitino as Abraham Lincoln was from Rod Blagojevich.

Those who played for him credit him with making them successful in life more than on the court. Most of his players have achieved great success in life and most outside of basketball. To a man, they sing his praises and none more so than Bill Walton.

In a statement released through UCLA on Saturday, Walton praised his mentor. There were two sentences in particular from that statement that really caught my eye.

“John Wooden represents the conquest of substance over hype, the triumph of achievement over erratic flailing, the conquest of discipline over gambling, and the triumph of executing an organized plan over hoping that you’ll be lucky, hot or in the zone.”

“John Wooden also represents the conquest of sacrifice, hard work and commitment to achievement over the pipe dream that someone will just give you something, or that you can take a pill or turn a key to get what you want.”

Wow, I never heard a better or more succinct explanation of why some succeed while others do not. Wooden was famous for his “Pyramid of Success” which you can read and have explained by the Wizard of Westwood himself at his website. I am not much for self-help gurus. The only thing most of them have ever been successful at is selling self-help books and lectures. Maybe if Tony Robbins had won 88 games in a row, like UCLA did, I’d buy his books. But Wooden did succeed; as a player he was a National Champion and Hall-of-Famer; as a Coach no one came close; as a husband, father, grandfather, friend, and citizen it would be hard to find anyone so loved and respected.

Wooden’s philosophy on success is applicable to any endeavor in life. For example, those two sentences from Bill Walton are probably the best advice you could ever give any trader: “Discipline over gambling….executing an organized plan over hoping that you’ll be lucky…sacrifice, hard work, and commitment over the pipe dream that someone will just give you something…

This is the philosophy that we try to teach here. In trading there are, as Walton says, no pills to take or keys to turn, although some of our competitors are selling just that. We tell our students that the keys to success in trading are those same things that Coach Wooden taught on the hardwood: Commitment, sacrifice, hard work, and discipline.But you also need to know what you are doing, and that is where we come in. In the middle of Wooden’s pyramid is a box labeled “Skill”. Wooden said “At the very center of the Pyramid of Success is Skill. You have to know what you’re doing and be able to do it quickly and properly”. We can help you with that part of the pyramid; the rest is up to you.

So stop all of your “erratic flailing” and join us.

The VIXclosed near its high at 40.95.How could a trader take advantage of the abnormally high implied volatility without exposing themselves to significant market risk? They could start buying the SPY May 112 Straddle at the close on May 7th. Before you come to the conclusion that I’m crazy and stop reading this let me tell you that there is another part of this trade. That would be selling the SPY December 124 Call and the SPY December 100 Put. The May straddle could be purchased for 6.50 while the December strangle could be sold for 11.01 for a net credit of 4.51.

The following Monday the Greek debt situation was apparently resolved. SPY opened at 115.81 and closed at 116.16. The May straddle closed at 6.04 while the December straddle closed at 9.21. The May/December strategy would have resulted in a 1.34 profit (6..04-6.50 = -.46, 11.01-9.21 = 1.80, 1.80-.46 = 1.34)

The May implied volatility was actually higher than the December implied volatility when the position was established and the trade was still profitable. That is because the dollar amount of the options sold in December was greater. When there is an overall decline in volatility the trader still benefits.

What if the market sold off instead of running up? The trader’s May 112 puts would have caused their position to get shorter and shorter on the way down. Is there any situation where this trade would not have been profitable? Yes, if SPY opened at 112.0 and just sat there. That was a possible, although highly unlikely, scenario. Additionally, the position is structured so the trader can trade around the core position since the position gets longer on the way up and shorter on the way down.

For more on how to survive unexpected market volatility join us for our free webinar on Tuesday May 25th at 3:30 Central.

Click Here to Register for the free May 25th CST Webinar “Surviving a Market Meltdown”.

There’s also time to register Here for our May 20th free webinar presented in conjunction with Wall Street Horizon “Making Money Trading Earnings”.

Since 1929 the market has been haunted by memories of “Black Tuesday”. Now a new generation of traders and investors will be haunted by “Fat-Finger Thursday”, the unprecedented 600+ point melt down and subsequent melt-back-up that all happened in a matter of minutes. It was not the size of the drop that was so frightening it was the speed of the thing that left veteran traders gasping in disbelief.

I began trading stock index futures in 1982 and have traded through and witnessed firsthand the crashes of 1987 and 1997, had my picture taken by the AP on April 16^th, 2000 while surviving what was then the biggest one-day drop in Dow history, was in the Dow Pit when the planes struck on September 11, and sat at my computer watching the various meltdowns of 2007-2009. Through all that, I never witnessed anything like I saw last Thursday.

I was watching the market on my computer on Thursday afternoon and the Dow was down over 350 points on fears about the Greek crisis. Suddenly the market was down 400, 450, 500, 600, 800 points. I quickly checked and made sure there was no negative news that had just struck the market there was none, no terrorist attack, no more bad news from Greece, no new oil spill. I checked again and now the Dow was dipping below 10,000 down 995 points for the day. And then just as quickly it started back up and before long was back to being down 350 for the day. It was all over in twenty minutes. I know enough about trading stocks and their indices to know that humans cannot trade that fast. Obviously the machines had taken over but what, or who, had set them off?

I turned on CNBC in time to hear the first speculation about a “fat-finger” scenario. In the world of computer trading, “fat finger” refers to someone whose obese digit causes them to hit too large a number or to get stuck on a keyboard key. It generally refers to any accidental order entry or execution. Frankly, I was glad to hear that because my first fear was cyber-terrorism. However it began, the drop moved through the stock, ETF and futures markets with breakneck speed; one sell program setting off another like one of those domino videos that you see on YouTube.

How precipitously those dominos fell were astounding. For example, Accenture (NYSE:ACN) went from over $40 to $1. Some ETF’s were worse: The iShares Russell 1000 Value Index (NYSE:IWD) went from $60 to $0.08; the SPDR International Dividend ETF (NYSE:DWX) went from $40 to zero! Check the charts on these ETFs, I’ve never seen anything like it.

The first explanation was that an overly large order in Proctor and Gamble (NYSE:PG a Dow and S&P component) had caused the NYSE to shut down trading in PG and send the excess selling into the electronic market. PG, which had been trading above $60 suddenly ticked below $40. This could have caused program trading in index futures to accelerate which would have then led to sell-offs in individual stocks. However, when you look at real time quotes in PG and the Dow you can see the Dow had made most of its move before the low ticks in PG.

The story was that a 16 billion share order was entered to sell PG at the market. Which is a problem seeing as that PG only has 2.88 billion shares outstanding. This bad order was originally blamed on Citigroup because apparently on Wall Street it’s fun to kick someone when they’re down. When that didn’t fly they blamed a small Chicago brokerage because Wall Street also believes in blaming Chicago for everything. In 1987 they blamed S&P traders for the crash, and all these years later I can finally admit it, It was us, it was our revenge for the Mets catching the Cubs in 1969.

Since then the head of the NASDAQ blamed the NYSE and its parent company Euronext, and then the NYSE chief made the point that, unlike the NASDAQ, the NYSE is capable of “going manual”. Needless to say, the resulting explanations and finger (fat or otherwise) pointing has done nothing to assuage my fears. Now the Government is saying there was no “fat finger” and they are continuing to investigate what caused the incident. Expect more Congressional hearings, press conferences and some new rules and safeguards.

While the government and the exchanges worry about their next set of safeguards, what about your safeguards? Where were customers filled on the sell stop orders or their market orders during the panic? How much money was lost and, perhaps more importantly, how much confidence in the markets was lost on “Fat-Finger Thursday”? If you were a victim, or if know someone who was, please email us with any horror stories from that day. We want to use them in an upcoming online seminar.

At the Chicago School of Trading, we have decided to assemble a panel of experts in a free, live webinar on how a small investor or trader can protect themselves from the next market meltdown. In this column next Monday we will post the date and time of that forum with a link for registration. Please join us, no matter how chubby your fingers are.