Tomahawk, WI 8/26/2013 (BasicsMedia) –Look through the recent decades of innovations in the bubble world of finance, and you will notice that ETFs are the few products that are still going strong. While being the hottest selling product 17 years ago, ETFs have settled in and matured. In current (still) volatile markets, it is time to review what ETFs can offer. While there are several different ETFs floating around, this reading will highlight the ones based on the financial sector, and specifically, on the Direxion Daily Financial Bull 3X Shares (NYSEARCA:FAS) and Direxion Daily Financial Bear 3X Shares (NYSEARCA:FAZ).

This is a 101 for those who are waking up to the new and quick opportunities that the world of investing claims to offer. What follows is not only an insight into the FAS and FAZ but also a guide into the risks of such trades.

Exchange traded funds closely resemble mutual funds in their structure and behavior. Like mutual funds, ETFs are also structured on underlying assets that can ordinarily be purchased on the open market.

However, unlike mutual funds, which are broadly defined, ETFs usually track a particular index. ETFs also trade on the open market during normal trading hours with price fluctuations throughout the day. For example, SPY (SPDR S&P 500) tracks the returns of the S&P500.

Other examples include DTO which tracks the inverse daily movement in the price of a barrel of crude oil while TYH follows the daily return of Russell 1000 Technology Index.

Shorting on your belief of dropping oil prices on any given day, you can get a double short position by buying DTO and while believers in technology can get a triple long position by purchasing TYH.

Typically, individual ETFs exceed volumes of common stocks.

What is FAS and FAZ –

Direxion Shares offers and ETF, the Direxion Daily Financial Bull 3X Shares or FAS in short. The aim of this ETF is to return triple the daily return of RIFIN (The Russell 1000 Financial Services Index).

The Russell 1000 Financial services index consists of top 1000 companies based on market capitalization which provide financial services. New companies are added and any companies that have significantly shifted their economic orientation away from the financial services sector are removed.

Therefore, if the RIFIN were to rise 10% in one day, Direxion would attempt to increase the market price of FAS by 30% over that same day. Likewise, a 10% drop in the RIFIN in one day would convert into a 30% fall in FAS the same day.

Because this is a daily ETF, Direxion does not attempt to mimic any returns longer than the horizon of the market close of the previous trading day to the market close of the succeeding trading day.

To ensure this objective, FAS is composed of approximately 1/3 securities that are within the Russell 1000 Financial Index and the rest is derivates of the RIFIN, specifically swaps.

Direxion Shares also offers the Daily Financial Bear 3X Shares (FAZ), another ETF which is the opposite of the FAS. The goal of this ETF is to return triple the inverse of the daily return of RIFIN.

Therefore, if the RIFIN rises 10% in one day, Direxion will attempt to decrease the market price of FAZ by 30% over that same day.

To round off in layman’s terms, the FAS Is for financial bulls and the FAZ is for the financial bears. A $100 position in the FAS will be worth $103 after a single-day mode of 1% in the underlying, while the same move in the FAZ will leave your $100 investment worth $97. Important to note is that these ETFs share a linear relation to the underlying return, excluding management and transaction fee.

In the volatile markets of today, ETFs have become very popular among short-term traders. Holding on to financial stocks in the recent times has been fairly hazardous to individual financial health. Short term investors talk about shorting both the FAS and FAZ to make big returns. The big problem with this trade is that it actually works. What also works is to long and short these two corresponding positions with the intent to offset and neutralize risk – also known as pair trades.

Whenever anything seems too good to be true it usually is.

The problem with shorting stocks that are leveraged 3x is the risk of a steep loss if the markets turn too quickly in any one direction.

Pair trades are sophisticated techniques that are applied by professional money managers, quant and hedge funds, with sophisticated calculative tools. As a result, the risk for retail, small time player is barely justified.

Returns of the ETF over time may NOT be even close to the returns of the index it is tracking. In 2009, the Russell 1000 index was up by nearly 30%. However, during the same period, the FAS actually lost 34%. So, if you actually followed the FAS v/s FAZ strategy, you would have been in the red!

As you now see, while ETFs (and pair trades) offer very quick gains, the underlying risk factors are relatively easy to forget. In closing, while it is easy to get sucked into the lure of leverage, it can leave you with high carrying costs. If you trade, you should only be trading very short term, and with small amounts only.

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