Leveraged ETF's

Investors, without paying margin costs (and not getting a potential tax deduction for investment interest) can now use a variety of ETF's to increase their chance of gains and losses.  

Amazingly enough, the ETF's have been created during the past couple of years.  One of the more popular ETF's in this category is the ProShares Ultra Financial ETF, or ticker UYG.  This ETF is leveraged 2x against the Dow Jones U.S. Financial Index (DJUSFN). 

Therefore, an increase in the index of 5%, leads to a gain of 10% for the holder of the security. Likewise, a loss of 10% in the index (really bad day), will lead to a loss for the security holder of 20%.  This all assumes, the price of the security on the previous day reached its actualy value.

Assume, that the price of UYG reaches $4.00 dollars on Monday.  The $4 dollars reflected the price paid for the security at the end of the day.  However, the actual net asset value of the ETF was $3.80. Therefore, even though the stock was trading at $4.00, the stock is mispriced by market demand, by 5.3%.  Therefore, if the next day, Tuesday, the index increases by 5%, implying a gain of 10% for investors holding UYG, the actual security will only be up 4.5% and investors will be complaining that the ETF does not follow the index.  Rather, it is just catching up to yesterday's error in pricing, based on market demand.  

Because of leveraged ETF's, especially the 3x leveraged ETFs offered by Direxion (popular ETFs include, FAZ and FAS), traders are finding volalitility even when the market lacks the movements they desire.  For the average investor, trading these ETF's can be a little challenging.  Especially if you do not have a day trading account, and have to stay in the ETF for the 3 days required by SEC regulations.  It is probably best to avoid the leveraged ETF's.  

Some commentators have blamed the financial volatility on the leveraged ETFs.  One is Mad Money host Jim Cramer.  I attribute this, to his inability to short because of the parameters of his Charitable trust and his need to find something to talk about on his show.  While, it is true that the relative firms have to trade to adjust their positions to the swings of the ETFs, those trades are a reflection of the market moves, and not their particular moves.  It is the investor that decides to buy or sell the index, not the firm sponsoring the ETF.