Using Options to Control Risk in Leveraged ETFs

Several readers noted that options on leveraged ETFs seemed like a recipe for disaster, as if no good could possibly come from piling leverage on top of leverage. While I certainly understand the sentiment, this type of thinking is typical of investors who have little or no experience in options. To the investor who is not versed in options, the options world often seems to be limited to an occasional covered call or an out-of-the-money call that is barely distinguishable from a lottery ticket – and seems to pay out just about as often.

In fact a large percentage of options traders are attracted to options because they are an excellent way to define, limit and manage risk. Yes, one can buy a put to provide protection for a long stock protection, but in the absence of owning the underlying (be it as stock, ETF, index or whatever), options traders are particularly fond of creating multi-leg options positions where the downside risk is known at the beginning of the trade and does not waver as long as the position is maintained.

Getting back to leveraged ETFs, I have reproduced a portion of the options chain for FAS, perhaps the most notorious of the Direxion triple ETFs, in the table below. With a current mean implied volatility of 126, FAS is a highly volatile ETF. FAS is so volatile that even with only 17 trading days remaining in the June calls, it is possible to sell the June 15 calls, which are 70% out of the money, for 0.05. The June 11 calls, which are 24.4% out of the money, can be sold for 0.40.

In terms of risk management, let’s say that an investor does not believe that FAS is going to rise more than 24% in the next 3 ½ weeks, so he or she decides to sell the June 11 calls, but hedge that position by buying an equal amount of the June 13 calls at 0.15. This is a bear call spread and will net $25 for each option contract, with a maximum loss of $175 per contract (not including commissions). The trade makes money if FAS expires at 11.25 or less, which means that the position can absorb up to a 27.2% gain in FAS. The trade offers odds of 7-1 ($175 to $25) and the maximum risk is defined up front and cannot change during the life of the trade.

This is but one example of how options can limit the risk of trading triple ETFs. There are many other potential examples.

The bottom line is that options trades can be structured in such a manner that they are much less risky than stock trades, even if the options are on volatile securities such as triple ETFs.

[As an aside, readers may have noticed that up to this point I have somewhat standardized on the options tools and graphics available through optionsXpress. Going forward, I will make an effort do a better job of highlighting some of the tools and content available at various other options brokers in order to illustrate some of what is available to the reader and at the very minimum, provide more visual variety.]

[source: OptionsHouse]

Disclosure: Short FAS at time of writing.