Do you like fine cars? The BMW M6 has become the dream car for many. The epitome of German engineering comes with a dual power setting. A mysterious power button that sits in the center console, offers the instant gratification to boost the engine’s power from 400 hp to 507 hp.

You may wonder what that has to do with ETFs. In short, leveraged ETFs are the BMW M6 of investing. With or without a power button, those ETFs offer high octane performance.

While BMW’s M6 can zoom you from point A to point B in a hurry, you may also find yourself wrapped around a tree if you’re not careful. Leveraged ETFs, just like the M6, can rack up profits at high speed, but can also crash your portfolio in no time.

Driving a fast car is fun, and investing with leveraged ETFs can be also, as long as you follow a few simply rules and guidelines; consider them your road signs. Don’t worry, there are no investment cops, but the market may punish you nevertheless, if you don’t follow the rules.

A look under the hood - the basics

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. Short component delivers the opposite or inverse performance of the index, whereas the leveraged feature magnifies the performance of the underlying index

Example: leveraged (long) ETFs

To illustrate, let’s take a look at a suite of leveraged ETFs. The objective of the Ultra S&P ProShares (NYSEArca: SSO) is to deliver 2x the performance of the S&P 500 (NYSEArca: SPY), while the Direxion Large Cap Bull 3x Shares (NYSEArca: BGU) aim to deliver 3x the performance of large cap stocks, as represented by the Russell 1000 Index (NYSEArca: IWB), there is no triple leveraged long ETF linked to the S&P 500.

In a perfect world, SSO will gain 2% if large cap stocks are down by 1%, while BGU would gain 3%.

Example: (leveraged) short ETFs

On the other end of the spectrum, the Short S&P 500 ProShares (NYSEArca: SH) aim to deliver the opposite daily performance of the S&P 500. The UltraShort S&P 500 ProShares (NYSEArca: SDS) aim to deliver twice the opposite daily performance of the S&P 500, while the Direxion Large Cap Bear 3x Shares (NYSEArca: BGZ) aim 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.

In addition to Direxion, ProShares, and Rydex, PowerShares and Van Eck offer ETNs linked to various commodities and currencies.

Lesson #1: Respect the leverage

If you are looking for a way to make or lose 60% in a few days, double or triple leveraged ETFs are the solution. The Ultra Real Estate ProShares (NYSEArca: URE), and its leveraged short cousin the UltraShort Real Estate ProShares (NYSEArca: SRS), 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. More about how to get the timing right in a moment.

Lesson #2: Account for tracking error

The objective of leveraged ETFs is to deliver a multiple of the underlying index’s DAILY performance. Notwithstanding a small margin of error, most ETFs are able to live up to their objective.

There is the misconception, however, that the magnified DAILY performance multiplied by a longer period of time, will also result in accurate long term performance mirroring. This is not so.

Due to the compounding effect of leveraged performance, the long-term performance of leveraged ETFs can deviate substantially from the underlying index. According to an in-depth study by ETFguide.com, the performance tracking error becomes particularly pronounced during periods of volatility (available in the April issue of the ETF Profit Strategy Newsletter).

The fourth quarter of 2008 marked such a period of volatility. Even though the Dow Jones (NYSEArca: DIA) was essentially range bound, some leveraged short ETFs deviated from their perceived long-term objective by 20% and more.

From the November 21st, 2008 lows to February 27th, the Russell 2000 (NYSEArca: IWM) gained a mere 2.38%, while the UltraShort Russell 2000 ProShares (NYSEArca: TWM) lost 25.41%. From 11-21-2008 to 3-3-2009, the Russell MidCap (NYSEArca: IWR) recorded a gain of only 2.77%, while the UltraShort Russell MidCap ProShares (NYSEArca: SDK) tumbled 28.35%. The UltraShort Financial ProShares (NYSEArca: SKF) even lost 45.53%, during a timeframe where the iShares DJ US Financial Sector (NYSEArca: IYF) broke even.

As much as volatility, especially in combination with a non-directional market, hurts the performance of leveraged ETFs, a directional market actually helps the performance of leveraged ETFs. This, once again, is due to the effect leverage has on compounding interest. Once more, timing is key.

Lesson #3: There might be 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 (NYSEArca: REC) got hit with distributions in excess of 80%. The UltraShort Industrial ProShares (NYSEArca: 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. The ETF Profit Strategy Newsletter continually informs investors in advance when the ex-dividend date is coming up.

The key ingredient - TIMING

As with so many investments and strategies, timing is key! The leveraged nature of these ETFs compounds the need for timing even more so. The ETF Profit Strategy Newsletter has proven to be a reliable source for finding the right entry and exit points.

The December 15th newsletter recommended adding (leveraged) short ETFs above Dow 9,000. From January 2nd to January 6th, the Dow sat above 9,000. The subsequent 2,700 point loss in the Dow resulted in triple digit gains for a number of recommended short ETFs.

The January newsletter identified Dow 6,000 to Dow 6,700 as a target range for a bottom. On March 2nd, just a few days before the Dow bottomed at 6,440, subscribers on record received a Trend Change Alert with the recommendation to buy leveraged long ETFs. Some leveraged ETFs have racked up triple digit gains since the March 2nd alert.

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. If you ever get a chance to drive the M6, do it. If you haven’t tried leveraged ETFs – long and short – simply follow the above steps, get your timing in order, and enjoy the ride.