Teeka Tiwari

What New ETF Rules Mean for You

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I'm sure you're familiar with using exchange-traded funds (ETFs) to play sectors, countries and indices. However, you may not know as much about a subset of this asset called leveraged ETFs, which has become a phenomenal trading tool for savvy investors.

In a strong trending market, these instruments have performed amazingly well. The key to these profits has been the massive leverage that these securities have opened up to the general public.

Generally speaking, the typical stock buyer can only leverage his funds at a rate of 2-to-1 via margin buying. However, some leveraged ETFs can offer leverage of 3-to-1. And when purchased in a margin account, that leverage gets boosted to 6-to-1!

Outside of the options and futures markets, individual investors just haven't had the opportunity to employ this kind of leverage before.

A Risky Bet

One problem with leveraged ETFs, however, is that they use futures and swaps to generate all of that leverage.

Price differences can emerge between different contract months on futures, which can lead to a wide departure between the performance of the leveraged ETF and the actual performance of the underlying securities supposedly represented by the ETF.

This is why, unless a strong trend is present, leveraged ETFs are better left as day trading tools rather than long-term strategic investments.

Many investors have found that out the hard way. Leverage is great when you're right, but it burns through your equity at an alarming rate when you are wrong. Just like most things in the market, many, many people get it wrong when trading these instruments.

Handle With Care

This doesn't mean that you can't or shouldn't use leveraged ETFs -- just know that if you're positioning yourself to make two to three times the returns, you also have to be ready for two to three times the losses if you're not careful.

For example, with 2-to-1 leverage, every 1% move in the ETF translates into a 2% move for you -- which is great if it's in your favor, but potentially devastating if you didn't use a tight stop-loss or if you bought on margin.

The investment message boards are replete with horror stories of investors blowing up their accounts with leveraged ETFs. Perhaps this is why the Financial Industry Regulatory Authority (FINRA) has recently imposed new margin requirements on these securities.

On Dec. 1, new rules went into effect that are a real blow for savvy investors who have been raking in the cash with leveraged ETFs. But I think we all knew that the free ride couldn't last forever.