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Just Released: August 2016 ETF Edge — Learn More

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Exchange-traded funds have found their way into countless portfolios, as investors of all types have embraced their cost-efficient, diversified exposure to virtually every corner of the global market. Given their liquidity and access, active traders have increasingly expanded their playbook to include ETFs, which are accounting for a greater share of trades. Leveraged ETFs have become especially popular within these groups, but can be dangerous for the inexperienced.

Leveraged ETFs: Fact Vs. Fiction

Leveraged ETFs use financial derivatives and debt instruments to consistently amplify the returns of an underlying index. For example, the ProShares Ultra S&P 500 (SSO A) aims to provide two times the daily performance of the S&P 500, as compared to the popular S&P 500 SPDR (SPY A), which provides only non-leveraged exposure to the benchmark index. This leverage is made possible through swap agreements and futures contracts [see The Ultimate Guide To Leveraged ETFs].

However, there are many key risks that traders and investors should keep in mind before trading these securities, ranging from basic risks associated with leverage to complex risks associated with compounding returns on a daily basis. In this article, we’ll take a look at seven mistakes that traders and investors should avoid when trading leveraged ETFs, as well as some ways that the problems can be side-stepped in order to preserve capital and avoid excess risk.

1. Be Wary of Holding Overnight

hand touching a line chart

Suppose an investor purchases a leveraged ETF for $100.00 and it ends the day up 10% at $110.00 and the investor realizes a 2x profit of 20%. The next trading session, the leveraged ETF falls 9.1% from $110.00 to $100.00 and the investor realizes a 2x loss of 18.18%. While this doesn’t sound all that bad on the surface, an 18.2% loss on $120.00 amounts to $21.84, which puts the position at just $98.16. In effect, a loss is realized on what would have been a neutral position [see How To Swing Trade ETFs].

2. Compounding Works Both Ways

As the example above illustrated, volatile markets can lead to big losses for leveraged ETFs due to the fact that compounding works both ways. Suppose the aforementioned leveraged ETF sways by the same 10 points every two days over a 60-day period and investors continue to hold it. While the underlying index may be dead even at $100.00, the leveraged ETF position would be down by more than 50%, if repeated 30 times, resulting in a significant loss.

3. Watch the Reset Period

The majority of leveraged ETFs reset their exposure daily, which means they amplify returns over the course of a single day. So, when considering the performance over a week, the performance depends largely on the path the ETF takes. While this isn’t a problem in trending markets where visibility is clean and simple, seesawing markets are a different story and can quickly erode returns in the same way that we saw in the example above [Download 101 ETF Lessons Every Financial Advisor Should Learn].

4. Be Aware of Derivative Risks

Since they use financial derivatives, leveraged ETFs are inherently riskier than their unleveraged counterparts. The additional risks come in the form of counterparty risk, liquidity risk, and increased correlation risk. Meanwhile, traders also have to consider external factors such as the impact of leverage on portfolio volatility. For example, leveraged ETFs may not be appropriate for retirement portfolios trying to maintain a low beta coefficient.

5. Active Traders: Use With Caution

Leveraged ETFs can be difficult to analyze and scary to some traders. However, their usefulness makes them difficult to ignore in many cases since they can be used to effectively trade on margin. That is, rather than borrowing money from a broker, traders can simply buy a leveraged ETF with cash on hand in order to accomplish a specific trading objective. But be aware, leverage is a double-edged sword, with a bigger move down being just as possible as a bigger move up.

6. Long-Term Investors: Stay Away

Leveraged ETFs may seem appealing to long-term investors given their ability to amplify investment returns. But, as we’ve seen above, there are great risks to holding them over a long period of time, which makes them a riskier bet for long-term investors. Long-term investors may want to instead consider purchasing traditional ETFs on margin, enhancing the leverage on their positions using call options, or employing other more traditional techniques [see How To Take Profits And Cut Losses When Trading ETFs].

7. Keep an Eye on the Costs

Leveraged ETFs can be more expensive than traditional ETFs due to the complex strategies they must employ to obtain leverage. For example, the Direxion Daily Financial Bull 3x (FAS A-) has an expense ratio of 0.95%, and the ProShares Ultra S&P 500 (SSO A) costs 0.92%. ETFs that track these major indexes without leverage often cost less than 0.1%. Traders should carefully consider these costs and their impact on returns when buying and selling leveraged ETFs.

The Bottom Line

Leveraged ETFs are a valuable tool for active traders looking to leverage their position without the use of margin or options. However, there are many risks associated with using these ETFs that traders and investors should be aware of beforehand. Knowing these risks, long-term investors may want to shy away from holding leveraged ETFs, while active traders utilizing them should always be mindful of their position.

Disclosure: No positions at time of writing.

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