Today I want to take a moment and talk a bit about leveraged ETFs. Once you understand the basics you can begin to use these vehicle investments to your advantage.

Leveraged (long) ETFs intend to deliver 2x or 3x the daily performance of the underlying index. Short ETFs intend to replicate 1x, 2x, or 3x the daily inverse performance of the underlying index. The leveraged feature magnifies the performance of the underlying index.

I use leveraged ETFs when I feel the market is going down because it is much easier than shorting stocks or buying Puts. To illustrate, let’s take a look at a suite of leveraged ETFs we can use in place of shorting.

The Short S&P 500 ProShares (SH) aims to deliver the opposite daily performance of the S&P 500. The UltraShort S&P 500 ProShares (SDS) aims to deliver twice the opposite daily performance of the S&P 500, while the Direxion Large Cap Bear 3x Shares (BGZ) aims to deliver triple the opposite daily performance. A 1% loss in the S&P 500 would (ideally) translate into a 1% gain for SH, a 2% gain for SDS, and a 3% gain for BGZ.

As you see above, BGZ offers the opportunity for the largest gains when the markets move down. If you are more conservative and want to take less risk, you could switch from BGZ to SDS or SH.

These are the three ETFs for the S&P 500. The other indexes have ETFs to replicate their return also. However, at the time of this writing the NASDAQ was outperforming the other indexes so I wouldn’t use any ETFs to short against that index.

There are also some dangers to leveraged ETFs. If you are looking for a way to make or lose 60% in a few days, double or triple leveraged ETFs are the solution. In volatile times, many of these ETFs can fluctuate 25% and more on any given day.

Such leverage needs to be respected and used responsibly. Buying a leveraged (long or short) ETF at an inopportune time can set your portfolio back real quick. Timing is a key component for investing in general, and investing in leveraged ETFs in particular.

You also might be faced with serious tax consequences. In order to manufacture magnified returns, leveraged ETFs have to resort to investment strategies that include swaps and futures. Swaps and futures are the most effective way for short ETFs to create the inverse performance.

This, however, also disqualifies them from the traditional in-kind redemption process which has given ETFs a reputation of tax efficiency. Up to 85% of leveraged long ETF assets could be allocated to securities of the underlying index, with the remaining portion invested in swaps and futures.

Tax distributions for many ETFs reached double digits in 2008. Shareholders of the Rydex Inverse S&P Energy ETF (REC) got hit with distributions in excess of 80%. The UltraShort Industrial ProShares (SIJ) paid a taxable distribution of over 44%. This tax hit can be avoided by simply not owning susceptible ETFs on the ex-dividend date.

Even though leveraged ETFs have their flaws, those flaws are far outweighed by their benefits. The key is knowing how and when to use them.