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How To Choose The Best Leveraged ETF For You

It feels like deja vu all over again Since May the stock market has been in a funk, commodities have back off and precious metals had been acting bearish (silver has been smashed). Junior mining stocks have been one of the hardest hit areas dropping over 20% and even the resilient oil stocks have managed to pull back a bit.

One of the worst performing sectors of the market over the past few months has been financials. In fact, if you look at a 6 month chart of the financials (represented by XLF) you can see that it is up only 2% since the start of QE2 versus a 20% gain in the S&P 500.

About a week ago investor sentiment reached extreme lows regarding the stock market and precious metals. When you are in a seasonally soft period and investor sentiment reaches a negative extreme its always a good time to put some money to work.

Since my background is in futures trading I tend to like using a bit of leverage, but since I dont watch the markets as closely as I used to I tend to favor leveraged ETF strategies instead of futures contracts. Most leveraged ETFs are basically a futures position that provides 200-300% leverage disguised as a stock. Its not for everyone, but compared to futures trading it feels like a walk in the park. Also, it allows you to have a little more diversification and use a little bigger stop without risking such a huge percentage of your capital. I wanted to buy a combination of the things that have held up best (biotech, oil stocks & gold) and the things that are most beaten up (silver & financials).

I split my investment evenly between these 5 areas and chose the investment vehicles that I thought would provide the best risk/reward scenario. For the beaten down financials I chose the leveraged financial ETF (FAS). This ETF from Direxion tracks the Russell 1000 financial index and provides 3x leverage, so it is capable of substantial moves. If there is a modest recovery in financials this fund can provide a strong return.

In the precious metals I chose to invest in the junior mining stocks ETF (GDXJ) instead of buying physical gold. This is because junior mining stocks have retreated 22% while gold has remained near all time highs. This divergence was very likely to play out in favor of a rise in gold mining stocks. When gold mining stocks rally the juniors tend to outperform the larger companies, so even though its technically not a leveraged ETF the companies themselves tend to be small and highly leveraged to the price of gold. The interesting thing about Gold was that even though gold remained near all time highs, investor sentiment had plummeted to 3 year lows. This provides an excellent low risk opportunity.

Unlike gold, silver prices have been smashed since topping near $50 an ounce this spring. They had corrected nearly 40% off the highs and all the weak longs were wrung out of the market. This was confirmed by a precipitous drop in the level of open interest in the comex silver futures. Normally I wouldve bought the silver futures but this springs volatility left a sour taste in my mouth (& some painful losses) so this time I chose the Leveraged Silver ETF (AGQ) from ProShares. This fund is a 2x leveraged fund and seeks to replicate 200% of the daily London silver price fix. It was the best performing ETF of 2010 and will shine again this fall if silver heats up. Silver recently broke out of its downtrend so things are looking promising.

Biotech has been in a very strong bull market versus the S&P 500 over the past year. Normally I shy away from markets that have already had an extended move but Biotech is one of those areas that can continue to run much longer than anyone expects. Im participating by purchasing the leveraged biotech etf (BIB) and am using the recent low as my stop.

The last area I chose was the Oil Sector as oil prices have backed off their highs but remain high enough to offer tremendous profit potential for the entire oil sector. Due to my fondness of leverage once again I chose the 300% leveraged oil etf (ERX). This ETF is not for the faint of heart as it regularly moves $3-4 per day and will even move 10-15% in either direction in a very short period of time. As you can see this ETF has crushed the S&P 500 over the past year and I will exit this trade if we take out this summers low (around $60).

The time to put money to work is when investors are the most pessimistic and are scared of the market. The levels reached this summer in both precious metals and the stock market created great entry points. The odds of making new lows in any of these ETFs appear to be quite slim, but if it occurs I will not hesitate to exit the trades. If Bernanke decides to purse further QE strategies these investments will soar!

On the other hand, we are close enough to the summer lows to use them as Stop Points to exit with small losses in case we are wrong. This is the type of situation I try to look for in markets.