A Smarter Way to Leverage Your Investments?

When markets fall, investors get impatient and look for ways to earn their money back quickly. That makes it a perfect environment for those offering products that promise amplified returns from market movements in either direction.

But as many investors have found out the hard way, you have to read the fine print to understand exactly how these products work. Otherwise, you won't get the results you expect.

Object lesson: Leveraged ETFs
A recent Barron's article discussed the trouble some investors have had with ETFs that use leverage to multiply the returns of their underlying indexes. Although the funds are designed to produce twice or three times the index return on a daily basis, they don't necessarily track the movement of the index over longer periods of time.

That created some strange results last year. One bear-market fund -- a fund designed to produce positive returns when stocks fall -- was supposed to pay investors three times the percentage drop in the Russell 2000. But even when the index was down slightly over a two-month span, the fund didn't gain -- instead, it lost 31% of its value. Similarly, over a different period, a leveraged bull fund lost value even though the index gained.

Perhaps most astounding are pairs of bull and bear funds that both drop over long timeframes. Here are some examples:

Index

1-Year Return of Bull Fund

1-Year Return of Bear Fund

Oil (DIG, DUG)

(63.8%)

(34.7%)

Chinese stocks (FXI, FXP)

(49.4%)*

(50.9%)

Real estate (URE, SRS)

(85.6%)

(41.4%)

Source: Yahoo Finance as of Jan. 26. *Unleveraged fund. All other funds are leveraged for 2x returns.

You'd think that either bulls or bears would've made money. Yet with these ETFs, it didn't matter which way you bet -- if you held onto these funds all year, you lost money.

Know your investment
The key here is that investors picked ETFs that focused on daily returns. If they wanted leverage for a longer period, they should have picked an investment that was better suited for that purpose. One way would be to buy stock on margin, but that has its own dangers. Yet there's an alternative using options that's somewhat safer.

For instance, say you want to double your bet over a period of months. One easy way to do it is to buy call options that cost roughly half the current price of the stock. If you do that, you can use the same money that would buy 100 shares of stock to buy options on 200 shares -- essentially doubling your exposure.

Here are some examples of how this option strategy can work in real life:

Stock

Stock Price

Option

Option Price

Wells Fargo (NYSE: WFC  )

15.48

April 7.5 call

8.80

Microsoft (Nasdaq: MSFT  )

17.63

January 2010 10 call

8.00

Apple (Nasdaq: AAPL  )

89.64

July 45 call

45.35

Potash Corp. (NYSE: POT  )

76.80

January 2011 45 call

43.10

Intel (Nasdaq: INTC  )

13.38

January 2010 7.5 call

6.25

Research in Motion (Nasdaq: RIMM  )

50.71

June 30 call

22.95

Source: CBOE. Closing price as of Jan. 26.

Let's take a closer look at Apple. To buy 100 shares, you'd spend $8,964. Or you could buy call options on 200 shares for $9,070. If you bought the stock and it rose to $100 by mid-July, your shares would be worth $10,000 for a profit of $1,036. On the other hand, the options would be worth about $55 per share or $11,000, for a profit of $1,930 -- almost twice the profit from buying the stock, just as you wanted.

Of course, if the stock drops, you'll suffer a double loss. But that's the trade-off you make with leverage.

By choosing the expiration, you get to set the period over which your returns will be measured. Because options have time value, you may have to pay extra for longer-dated options -- but once you do, you never have to worry about the tracking errors that leveraged ETFs face.

Or just skip it
Personally, I think most investors never really need to bother with leveraged investments. Plain old ETFs like SPDR Trust (AMEX: SPY  ) are good to give you broad exposure to the market. The Wall Street crisis has taught everyone how risky leverage is, and stocks are risky enough without going for broke.

Nevertheless, if you really think you need to make a leveraged bet, at least make sure you use the right tool for the job.

For more on investing the Foolish way, read about:

You don't need leverage to make good ETF and mutual fund investments. Our Motley Fool Champion Funds newsletter comes up with great picks every month, along with helpful advice on which funds to buy and which ones to get rid of. Try it out free with a 30-day trial.

Fool contributor Dan Caplinger avoids leverage. He owns shares of SPDRs. Microsoft and Intel are Motley Fool Inside Value selections. Apple is a Motley Fool Stock Advisor recommendation. The Fool owns shares and covered calls of Intel. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is no gamble.


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7/30/2014 4:00 PM
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