If you’ve ever been around risk-tolerant traders, you’ve probably heard of leveraged exchange-traded funds (ETFs).
Leveraged ETFs are different from your traditional ETFs, like the SPDR S&P 500 Index ETF (SPY) or the PowerShares QQQ Trust (QQQ), because instead of merely replicating the index, they aim to provide multiple times the daily performance of the underlying indices. They get that variance through the use of derivatives.
That said, let’s take a look into how leveraged ETFs work.
Leveraged ETFs explained
Leveraged ETFs aim to keep a constant amount of leverage usually over a one-day period. In other words, these ETFs aim to amplify the percentage changes in an underlying index. For example, if a two-times leveraged ETF is tracking the S&P 500 Index, and the index is up 1% on the day, the ETF would be up around 2% on the day. This allows speculators to take advantage of the underlying index’s short-term movements.
There also are ETFs that move against the index, so if you expect, say, technology stocks to fall, you could buy an inverse 2X tech ETF, and if the index drops by a point, the ETF should gain 2 percent; of course, if the index gains a point, you do double the inverse, and lose 2 percent.
Leveraged ETFs tend to be risky and costly, and should never be used as long-term investments. This is due primarily to the compounding of daily returns. If you hold onto a leveraged ETF significantly longer than its specified tracking period, your returns will vary significantly from the return of the target index.
On a daily basis, the movements in the underlying indices and leveraged ETFs are, more or less, the same. Check out the daily chart on the Direxion Daily Gold Miners Bull 3X ETF (NUGT) and its underlying index.
However, if you held on one day when the index was up, thinking it would rise the next day, and got long NUGT, the daily volatility — and the decay that leaves returns removed from the benchmark numbers over time — would have you in for a rude awakening.
Leveraged ETFs are investment power tools, and you should only hold them for the specified tracking period, and use them with appropriate stop-losses and profitable exit points. The Securities and Exchange Commission, among others, warns investors that leveraged ETFs are not long-term investors for buy-and-holders, so use them as a trading vehicle for daily and swing trades, but don’t mis-use them and hold them too long, because that’s how you wind up shooting yourself in the foot.
Jeff Bishop is lead trader at TopStockPicks.com. He runs short-term trading strategies, using stocks, options and leveraged ETFs.