Minyan Mailbag: Leveraged ETF Empire Strikes Back

Dear Professor Warner,

I don't see why people think the inverses are so awful. There's nothing you can do with inverse ETFs that you can't do with puts. You've been able to buy puts in IRAs for years (though not all brokers allow it). You can also sell futures in retirement accounts (but again, many brokers don't permit it).

The only thing that these instruments do is they make it appear easier to take leveraged bets. Most people know they don't understand options, but they think they understand ETFs. Also, brokers seem to be more willing to let people trade ETFs instead of options. But any kind of strange distortions that they'll cause are caused just as much by options. And that includes making the uptick rule useless.

One reason that the leveraged ETFs are more popular than options is the liquidity. You'll never get the same liquidity in options as you do in these ETFs, because there are too many different strikes to trade and quote, and the hedging strategy requires minute-by-minute adjustment instead of once a day. The spreads are quite small when trading leveraged ETFs, so you can actually use them for quick trades.

They'll do reverse splits when the prices go too low. I think they're too popular to be banned, especially since there is no real benefit to banning them. Although it might be a good idea to separate them out as a different class of instruments and require explicit permission, extra paperwork and waivers to trade them, like options have. That way, people won't just think that they can buy SSO and leave it for 40 years and expect to get twice the returns of SPY.

Thanks,
Minyan JKW


Dear Minyan JKW,

I really can't add much more to this question - you're spot-on, in my humble opinion.

The liquidity point is important, however. Yes, puts can do the same thing.

Remember the uproar about those BSC March 30 puts that traded almost exactly a year ago today? If anything, puts can prove more dangerous, considering the leverage they provide. Even the most active option gets dwarfed by leveraged-ETF volume when you factor in the stock equivalency.

One hundred shares of SKF translates into about 1200 shares of IYF, or about 4500 shares of XLF. You would then have to buy 24 ATM (50 delta) puts in IYF, or 90 ATM puts in XLF to replicate the selling pressure of 100 shares of SKF. And SKF trades approximately 20 million shares per day - which would equate to about 36 million XLF ATM puts. The open interest combined in the March 7 and 8 puts is about 310,000.

Bottom line: Options just don't trade with that kind of size or liquidity.

I don't want to sound like I think they're awful, though, and I'm not scapegoating here. On the blame scale, buyers and traders of SKF and FAZ rank pretty low. I would say, however, I believe they should have never come to market to begin with.