Hedging with Leveraged ETFs

StatsEdgeTrading

Hedging with Leveraged ETFs

When the market looks bearish, I avoid shorting weak stocks directly. Here’s why:

1. Historical Performance: The market tends to drift upwards over time, making it difficult to build reliable short-side strategies.

2. Skill Set: Shorting stocks is not my strength. It requires a different skill set.

3. Tax-Advantaged Accounts: In accounts like Canadian RRSPs or IRAs, shorting is not allowed.

Instead, I use leveraged ETFs, which are designed to provide magnified returns of an underlying index. Here’s an example of a recent trade:

Benefits and Risks of Leveraged ETFs

Benefits:

1. Hedging:

   • These ETFs allow me to hedge my portfolio without selling my long positions. For example, instead of selling stocks that are performing well, I can buy SQQQ to protect against potential losses.

2. Leverage:

   • Using leveraged ETFs means I can use less capital to achieve the same level of risk. This is particularly useful in tax-advantaged accounts where shorting isn't an option.

Risks:

1. Decay Over Time:

   • Leveraged ETFs are designed for short-term trades. They decay over time due to the nature of the derivatives they hold. Holding them long-term will result in losses regardless of market direction.

2. Volatility:

   • These ETFs are highly volatile. It’s crucial to have a stop loss in place to manage risk effectively.

Example: LABU

• LABU is a triple-leveraged ETF for biotech stocks. Its price history illustrates the risk of holding leveraged ETFs long-term. It appears to have been extremely high in the past due to the compounding effects of daily leverage, but it was never actually at those levels. This demonstrates the importance of using these instruments for short-term tactical trades only.

Conclusion

Leveraged ETFs offer a powerful way to hedge a long-biased portfolio. They allow you to take advantage of short-term market movements without needing to short stocks directly. However, it's essential to understand the risks and to use them as part of a well-defined, short-term strategy.