7 Key Guidelines to Trading Leveraged ETFs

11/28/2013 6:00 am EST

Focus: ETFs

Leveraged ETFs are a valuable tool for those looking to leverage their position without the use of margin or options, but there are many risks associated with them as well that you should be aware of, writes Justin Kuepper of ETFdb.com.

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 markets. Given their liquidity and access, active traders have increasingly expanded their playbook to include ETFs, 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 in order to consistently amplify the returns of an underlying index. For example, the ProShares Ultra S&P 500 (SSO) aims to provide two times the daily performance of the S&P 500, as compared to the popular S&P 500 SPDR (SPY), which provides only one times exposure to the benchmark index. This leverage is made possible through swap agreements and futures contracts.

But, 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 avoided in order to preserve capital and avoid excess risk.

1. Be Wary of Holding Overnight
Suppose that you purchase a leveraged ETF for 100.00 and it ends the day up 10% at 110.00 and you realize a 2x profit of 20%. The next trading session, the leveraged ETF falls 9.1% from 110.00 to 100.00 and you realize 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, you’d realized a loss on what would have been a neutral position.

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 that the aforementioned leveraged ETF sways by the same 10 points every two days over a 60-day period and you continue to hold it. While the underlying index may be dead even at 100.00, your leveraged ETF position would be down by more than 50%, if repeated 30 times, resulting in a significant loss.

NEXT PAGE: 5 More Mistakes to Avoid

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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.

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, but 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. However, 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, making 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.

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) has an expense ratio of 0.95% and the ProShares Ultra S&P 500 (SSO) costs 0.92%, while ETFs that track these major indices 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.

By Justin Kuepper, Contributor, ETFdb.com

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