Some choices…
We earlier had an article on the VIX, now for some more protective strategies if you believe the markets have further to fall (a possibility we certainly don’t exclude, although Goldman Sachs has just argued it expects the market to rally into the summer, and who are we to disagree with them :))

Some strategies

• Buying short leveraged EFTs
• Selling (shorting) long-leveraged EFTs
• Short both long and short-leveraged EFTs
• Buy calls on short-leveraged EFTs
• Sell puts on short-leveraged EFTs (generally not a good idea)
• Sell calls on long-leveraged EFTs (generally not a good idea)
• Buy puts on long-leveraged EFTs

Please note that all of these involve considerable risk, but also considerable reward for lurches downward.

1) Buying short leveraged ETF’s

The first thing you should know is that holding on to these leveraged EFT’s for a considerable time is risky, because compounding effects. There is a lot of mystery about this, the easiest explanation is the following:

• Because most leveraged products operate with a focus on daily results, they will increase total exposure after a winning session and decrease exposure after a losing session. In oscillating markets–when wins are generally followed by losses and vice versa–this compounding of returns can quickly erode value. But in trending markets (e.g., when stocks head steadily higher), compounding can lead to returns greater than the simple product of the daily target multiple times the multi-session return on the underlying index. The final two quarters of 2008 and first quarter of 2009 served as a powerful illustration of the first scenario. Seesawing markets sent both bull and bear leveraged funds down sharply over the period, and the adverse effects of buying-and-holding during this stretch got a lot of attention from both financial journalists and government regulators. [ETF Database]

Here is another take on this:

“Whether the ETFs are leveraged, inverse or leveraged inverse, their re-balancing activity is always in the same direction as the underlying index’s daily performance: When the underlying index is up, the additional exposure of total return swaps needs to be added; when the underlying index is down, the exposure of total return swaps needs to be reduced.”

See also here for a more general explanation. The leverage is a daily one, keep that in mind.

Some candidates:

• BGZ: Direxion Large Cap Bear 3x Shares
• FAZ: Direxion Financial Bear 3x Shares
• DPK: Direxion Developed Markets Bear 3x Shares
• TYP: Direxion Technology Bear 3x Shares
• TZA: Direxion Daily Small Cap Bear 3x Shares
• SPXU: ProShares UltraPro Short S&P500
• UPRO: ProShares UltraPro Short S&P500

2) Shorting long-leveraged EFT’s

Here is a list of some triple leveraged ETFs

• BGU: Daily Large Cap Bull 3x Shares Russell 1000
• MWJ: Daily Mid Cap Bull 3x Shares Russell Midcap Index
• TNA: Daily Small Cap Bull 3x Shares Russell 2000
• ERX: Daily Energy Bull 3x Shares Russell 1000 Energy
• FAS: Daily Financial Bull 3x Shares Russell 1000 Financial Services 
• DRN: Daily Real Estate Bull 3x Shares MSCI US REIT Index
• TYH: Daily Technology Bull 3X Shares Russell 1000 Technology Index 
• DZK: Daily Developed Markets Bull 3X Shares MSCI EAFE Index
• EDC: Daily Emerging Markets Bull 3X Shares MSCI Emerging Markets Index
• TYD: Daily 10-Year Treasury Bull 3x Shares NYSE Arca Current 10-Year U.S. Treasury Index 
• TMF: Daily 30-Year Treasury Bull 3x Shares NYSE Arca Current 30-Year U.S. Treasury Index

It’s not that much different from the first strategy, but it protects even against volatility (as well as deep lurches downward, of course). See here for an explanation:

• As the graphs below show, the higher the volatility the more volatility drag it exerts on the LETF returns. 3X Bear ETFs are more susceptible to the Volatility drag than 3X bull ETFs. As in the table2 in the blue highlighted cells, if volatility is high enough, both long and short ETFs can lose almost all their value regardless of the market direction.

3) Selling (shorting) both long and short-leveraged EFT

From the graphs above showing the effects of volatility on the leveraged EFTs, in a volatile (but rather directionless) market, the returns of both long and short-leveraged EFTs suffer significantly over time, so one could short them both. However:

• This double-short strategy has a high probability of relatively small gains and a small probability of a very large loss. Under certain market conditions, such as strong directional movement (index return>20%, or index return<-20%) and low volatility (as in 10%), you could get cobbled by implementing this double-shorting strategy, as in the cells in table 2 highlighted in green.

4) Buying calls on short-leveraged EFTs

If triple leverage ain’t enough you can add more leverage even by buying calls, speculating on a market downturn. The nice thing is that you can only lose your option premium, although this sounds more friendly than it is. Due to the hefty volatility of these leveraged EFTs, options on them carry very large premiums.

5) Selling puts on short-leveraged EFTs

Selling puts is selling someone the right to buy these EFTs at a pre-ordained price (the execution price). Since you’re speculating on further market falls, this ain’t supposed to happen, as the short-leveraged EFT will rise with market falls. However, this is not a strategy we advice. Even in a stagnant but volatile market the short-leveraged EFT can fall in value, let alone if the market rises. If you don’t have the underlying value of these options (that is, the short-leveraged EFT), this could force you to buy it at much higher prices (the execution price) than the present market price. We don’t think this is worth the risk.

6) Selling calls on long-leveraged EFTs

Once again, do understand that selling naked options is extremely risky if the market doesn’t behave the way it’s supposed to. If the options become in the money you will have to deliver their underlying value (that is, the EFT shares). If you don’t have these, you might have a problem of portfolio threatening proportions. However this strategy enables you to collect the options premium in a downward, stagnant, and perhaps (depending on the execution price) even mildly upward market. We do think it’s not worth the risk though.

7) Buying puts on long-leveraged EFTs

This is a better strategy than the previous one, in our view. The maximum you can lose is the options premium, but you win in a downward and volatile market. As long as the market doesn’t lurch upwards, the leveraged bull EFT will decline and your put options become more profitable.

As an illustration, look at the graph of BGU (one of the more obvious candidates) These are Direxion Daily Large Cap Bull 3X Shares.

It went down from over $67 to $45, roughly 30%. You could have shorted them or bought put options.

Its counterpart is BGZ, Direxion Daily Large Cap Bear 3X Shares. Here is the graph:

It went up from $12 to almost $17, or almost 40%. Having been long on the leveraged bear shares would have provided a somewhat higher return than being short on the bull shares, indicating that the declines have been steep, compounding the returns of the leveraged bear EFT more than those of the leveraged bull EFT.

Conclusion

• If you expect the rapid decline to continue, buy the leveraged bear EFT (or buy calls on them), if you think there will be a more gradual decline with more volatility, shorting the leveraged bull EFT (or buying puts on them) could be (somewhat) more profitable.
• If you just expect volatility, you could play the VIX, as we suggested before.

Further reading

• ETF database
• Leveraged ETF Myth Debunked
• Leveraged EFTs: Understanding the Risks and Strategies
• 10 Common Myths About EFT Investing
• EFT Basics: What You Need to Know About Exchange-Traded Funds
• The Rise of Triple Leveraged EFTs
• 3 Ways to Ride the Volatility Wave
• Dissecting Leveraged ETF Returns
• If you don’t trust your own judgement (see here for promo)