After the big losses of 2008 and early 2009, investors were in a serious hurry to earn back the money they lost. That created a perfect environment for companies offering leveraged exchange-traded funds, which promise amplified returns from market movements in either direction. Even now, leveraged ETFs are still popular, as speculators try to guess the market's next big move.
But if you're looking for the kind of leverage that lets you truly multiply your long-term returns, then those ETFs aren't the way to go. Instead, there's a better strategy involving options. It'll give you at least a chance of making some serious money -- provided you pick the right stocks.
Why leveraged ETFs haven't worked
The reason leveraged ETFs have been so controversial, warranting warnings from financial regulators and even outright bans at some brokers, is that they don't work when you hold them over multiple trading sessions. Typically, these ETFs are designed to track indexes on a daily basis.
Although most of them do a good job of daily tracking, they simply aren't able to track those same indexes for longer periods of time. As a result, sometimes both the bullish and bearish ETFs tied to the same index produce substantial losses for ETF shareholders. Just take a look at some examples:
|Sector||3-Year Annualized Return of Bull Fund||3-Year Annualized Return of Bear Fund|
|Real Estate||(32.9%)||(66.5 %)|
Source: Yahoo! Finance as of Dec. 22.
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 over the years, you lost money -- a lot of money.
Know your investment
If you want leverage for a longer period than a single day, you need to pick an investment that's better suited to that purpose. One way would be to buy stock on margin, but that has its own dangers. However, there's an alternative using options that's quite a bit safer.
Say you want to use double leverage over a period of several months. One easy method to get that leverage is to buy deep in-the-money call options that cost about half what you'd pay for the company's stock. If you do that, you can buy options on 200 shares with the same money you'd pay for 100 shares outright. That doubles your risk -- and reward.
As an example, say you want to mimic the biggest positions in the publicly traded stock portfolio of guru investor Bruce Berkowitz, award-winning manager of the top-performing Fairholme Fund. But instead of just buying the stocks, you want to double your exposure. Here are the options you could buy to use this strategy in real life:
|Stock||Stock Price||Call Option||Option Price|
||55.76||Jan. 2012 $30||26.30|
||169.60||Jan. 2012 $85||87.50|
Bank of America
||27.40||Jan. 2012 $15||12.55|
Source: Yahoo! Finance. Stock and options prices as of Dec. 22 close.
For more detail, look at AIG. To buy 100 shares, you'd spend $5,576. Or you could buy call options on 200 shares for $5,260. If you bought the stock and it rose to $70 by next January, your shares would be worth $7,000, for a profit of $1,424. On the other hand, the options would be worth $40 per share, or $8,000, for a profit of $2,740 -- almost twice the profit from buying the stock, just as you intended.
Of course, if the stock price falls, you'll lose twice as much money. But that's the downside of using leverage.
Moreover, because options let you choose different expiration dates, you get to decide the length of time you want to measure your returns. Unlike leveraged ETFs, you're not stuck with the one-day timeframe. Now, 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.
Leverage is optional
Options open a number of interesting doors for investors, but not all of them involve any leverage whatsoever. Used wisely, they can be valuable tools to help you enhance your returns to generate extra income and attain better buying and selling prices -- just to name a couple.
Using call options intelligently is just one method that our Motley Fool Pro service has used to deliver strong returns since its launch. It's been closed to new subscribers for 18 months, but in January, the service will briefly reopen its doors. As a limited-time offer, though, you'll need to act fast. To learn more about Motley Fool Pro and how options and other investing strategies can help you make money, just enter your email address in the box below to get the latest information.
This article was originally published Aug. 12, 2009. It has been updated.
Fool contributor Dan Caplinger typically avoids leverage, but he's been known to buy an option or two here and there. He owns shares of Fairholme but doesn't own shares of the companies mentioned in this article. The Fool owns shares of Bank of America and is short Bank of America.
We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy gives you all the options.