Submitted by Ian Rayner on Thu, 2008-11-06 14:26.

I guess it's been a while since we discussed leveraged ETFs.

The "fear" regarding leverage in ETFs is a product of a failure to understand risk control in trading and a failure to understand the math of leveraged ETFs.

1) If something is leveraged all one needs to do to control risk is adjust position size and stops in direct proportion. That is, if you want to take the equivalent of $100,000 unleveraged position then take a $50,000 position in a 200% ETF or a $33,333 position in a 300% ETF. To limit losses you would size your stop in direct proportion to leverage: a $10 stop in the unleveraged instrument gives you the same protection as a $20 stop for a 200% and a $30 stop for a 300% instrument (provided your position is sized in accordance with the above). So via position sizing and stop selection we can always achieve the EXACT SAME risk as when using unleveraged instruments. The argument that leveraged ETFs are more risky than unleveraged ones is a canard.

2) Using a leveraged fund is a much better way of taking any position than using an unleveraged one. It is actually a lower risk option with better returns due to compounding (or reverse compounding in the case of an inverse fund).

Let's look at the math for a 300% inverse ETF.

First, let's say things go well (from a short's point of view) ... Over a 30 day period the market goes down 1% every other day and rises 0.5% the days in between. An index starting at $1,000 drops to $922.26 over 30 days. So as a short you are up 7.8% for a profit of $77.74. Using a 300% inverse fund, we bought $333.33 to ensure our initial risk is the same as shorting the index. We made 26.1% profit, or $86.95. We beat shorting the index directly by 10.6% FOR THE SAME INITIAL RISK.

Let's say, instead that we made a bum trade ... Over a 30 day period the market rises 1% every other day and falls 0.5% the days in between. An index starting at $1,000 rises to 1,082.29 over 30 days. So as a short you are down 8.2% for a loss of $82.29. Buying the same $333.33 as before we lost 22.0%, or $73.33. We lost 10.9% less than shorting the index directly.

So whether the trade was a good one or a bad one, the leveraged inverse ETF was better than taking a position directly in the index, for the same level of initial risk.

Bottom line ... don't bother reading anything a financial journalist writes. These people are ignorant.
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An additional point to note:
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Submitted by Ian Rayner on Thu, 2008-11-06 16:26.

An additional point to note: the numbers above illustrate that shorting a leveraged ETF is a stupid move - you will lose more if the market moves against you and make less if it goes your way than if you had gone long the opposite fund.

Let's say the market trends up according to the pattern suggested above (+1%, -.5%, +1%, etc) for 30 days.

If you went long the 300% long fund you would make $86.95 (26.1%). If, instead, you went short the 300% inverse fund you would make $73.33 (22%). i.e. An 18.6% greater profit going long the leveraged fund vs shorting the opposite.

If you bet wrong, and you had gone long the 300% inverse fund you would have lost $73.33 (22%). If, instead, you had shorted the 300% long fund you would have lost $86.95 (26.1%). i.e. A 15.7% smaller loss going long the leveraged fund vs. shorting the opposite fund.