How Do Leveraged ETFs Work?

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How Do Leveraged ETFs Work?

ETFs are an increasingly popular instrument among retail and professional investors alike. These funds enable you to invest in an entire market index or sector in a single trade, and they’re often quite inexpensive.

As ETFs have become more popular, so too have a related instrument: leveraged ETFs. These amplify the risk-reward ratio of your investment and can be highly risky if you don’t fully understand them. So, let’s take a closer look at how leveraged ETFs work and what to watch out for when investing in leveraged ETFs.

What is an ETF?

In order to understand leveraged ETFs, it helps to take a step back to the instrument that they’re based on. An ETF, or exchange-traded fund, is a basket of securities similar to a mutual fund. The most important difference between an ETF and a mutual fund is that ETFs trade on the stock market, so they’re accessible to anyone and can be traded throughout the day just like a stock.

ETFs are popular because they enable you to invest in all the stocks in a market index like the S&P 500 in a single trade. They can also give you exposure to a range of stocks within a specific market sector. Some ETFs are passively managed, while others are actively managed to try to beat the market.

Exchange Traded Fund

What is a Leveraged ETF?

A leveraged ETF builds on the concept of an ETF. These funds might mirror an index like the S&P 500 or a sector-specific index, but they will do so by investing in debt and derivatives instead of individual stock shares.

The net result is a fund that tracks the performance of, say, the S&P 500, but amplifies every price change. So, a 1% increase in the value of the index might result in a 3% increase in the value of the leveraged ETF. By the same token, a 1% drop in the value of the index would result in a 3% loss for the leveraged ETF.

How Do Leveraged ETFs Work?

Leveraged ETFs invest in baskets of securities, just like a traditional ETF. However, they achieve leverage by buying additional shares of the stocks in the fund on margin (that is, borrowing money to buy shares). They can also invest in derivatives like options contracts instead of buying shares. 

Leveraged ETFs can also short sell an index. These are often known as inverse ETFs. Inverse ETFs borrow shares and sell them short or purchase put options.

Fund managers need to carefully control how much leverage they take on with debt and derivative purchases in order to achieve the desired leverage level for the fund overall. Importantly, leverage is typically reset at the end of each day. This means that a leveraged ETF starts each trading day at its target leverage level, even if it ends at a different leverage (as a result of closing short positions or variation in option contract values).

One of the downsides of leveraged ETFs is that they typically have much higher expense ratios that standard ETFs that track the same index. This is in part because debt and derivatives cost money. When shares are bought on margin or short sold, the fund is responsible for paying interest on the borrowed money. Leveraged ETFs that purchase options have to pay contract premiums.

Examples of Leveraged ETFs

There are many leveraged ETFs available in the US. Some of the most popular are ones that track the S&P 500 and amplify its gains and losses, such as the ProShares Ultra S&P 500 (which aims for 2x leverage) and the Direxion Daily S&P 500 Bull 3X Shares (which aims for 3x leverage).

There are also inverse ETFs that short the market. For example, the ProShares UltraPro Short S&P 500 ETF is an inverse ETF that moves in the opposite direction of the S&P 500 with 3x leverage. The ProShares Short Russell 2000 moves in the opposite direction of the S&P 500, but without magnifying the size of price changes.

S&P 500

Things to Be Cautious about when Trading Leveraged ETFs

While leveraged ETFs can provide better returns than standard index ETFs when they’re trading in your favor, these instruments can be extremely risky. It’s important to recognize the unique risks that you face when holding leveraged ETFs.

Leveraged Risk

The most important risk to leveraged ETFs is that it’s not just the profits that are magnified – losses are as well. Say you’re invested in the ProShares Ultra S&P 500, which tracks the S&P 500 with 2x leverage, and the index drops by 5%. In that case, the value of your position will drop by 10%.

More significantly, since leveraged ETFs are typically reset on a daily basis, they actually lose money over time. To understand this, let’s look at an example.

Say an index fund drops from $100 per share to $95 per share, a loss of 5%. In that case, the ProShares Ultra S&P 500 ETF will drop 10%, from $100 per share to $90 per share.

The next day, the index gains 5%, bringing it back up to $99.75 – a net loss of 0.25%. However, the corresponding 10% gain in the leveraged ETF only brings the price up to $99 – leaving it with a net loss of 1%.

Thanks to this effect, leveraged ETFs lose more money when volatility is high. That can be counterintuitive even for experienced traders, so it’s important to carefully monitor how these funds are performing and to cut losses early.

Short ETFs Incur Extra Risk

Leveraged inverse ETFs are especially risky. The market generally goes up more than it goes down, so you’re often betting against the trend with the potential for amplified losses.

For example, take the ProShares UltraPro Short S&P 500 ETF, which is an inverse ETF with 3x leverage. If the S&P 500 rises by 2%, your position would lose 6% of its value in a day. It would then take more than a 2% loss in the index to break even on your position. That’s a significant amount of risk, even for investors with strong stomachs.

Trading ETFs

Conclusion

Leveraged ETFs enable you to speculate on movements in a market index or market sector, while amplifying the profit and loss you get compared to a traditional ETF. These funds are highly risky and tend to lose money over the long term. They are primarily suitable for short-term investors who fully understand the unique risks that come with trading leveraged ETFs.