Leveraged ETFs are a type of exchange-traded fund used by people who like to speculate.
An ETF is a security that trades on an exchange like the New York Stock Exchange and tracks the performance of an index such as the S&P 500. Leveraged ETFs are like ETFs on steroids. They take on debt or use the help of financial instruments like derivatives to increase the returns of the underlying index.
Think of them as an amplifier to a regular ETF. With a double-leveraged ETF, if the S&P 500 rose by 1% in one day then the leveraged ETF would increase by 2%. A triple-leveraged ETF would increase by 3%.
Naturally, these funds are highly volatile and present a huge risk to anyone trading them. Leveraged ETFs have grown popular amongst day traders because returns can be generated very quickly. It’s possible to profit but be prepared for plenty of ups-and-downs along the way.
Profiting from leveraged ETFs
Avoid Long-Term Trades
Anyone willing to take advantage of leveraged ETFs must avoid holding trades for too long. Holding leveraged ETFs for too long has the potential to quickly erode the value of your trading portfolio.
This is due to a few reasons. First, leveraged ETFs tend to have high expense ratios or management fees. Often they are twice as expensive as their more vanilla ETF counterparts.
That’s just the beginning. In addition to expense ratios, investors must bear the cost of re-balancing.
For example, let’s say you have a double-leveraged fund with $10 million in assets and $20 million exposure. The underlying index rises 1% in one day, and you make $200,000 (excluding expenses). The fund’s assets have increased to $10.2 million in assets, and total exposure has to be adjusted so that it is $20.4 million.
Leveraged ETFs are always making changes and adjustments like this and the longer you hold on, the more fees you are required to pay.
An option gives an investor the right, but not the obligation, to sell a security for a pre-agreed upon price. While this strategy should be reserved for more experienced investors, options can help reduce the inherent risk that comes with leveraged ETFs.
The beauty of options is that you are not required to do anything. If you own a leveraged ETF whose price drops then you can offload those ailing shares to another investor with whom you’ve drawn up an options contract. That investor is obligated to buy the securities at a higher price, and you get to decide whether or not to enforce it.
Manage your losses
Before trading leveraged ETFs, you must be able to handle losses better than the average investor. More than anything else, this is the most important part of working with these types of funds. They reset their exposure every day, so daily returns are amplified and compounded over time. Compounding works both ways, so consecutive down days can take their toll.
Understand all the risks and take appropriate steps to manage your losses and your psychology.
The Bottom Line
Trading leveraged ETFs can net investors large profits. However, they possess a high risk especially to newer or inexperienced investors who typically engage in long-term trading. Nonetheless, they are a great tool for wealth creation when you know which strings to pull.