Ever heard of leveraged exchange-traded funds?

Well, if you haven’t, they’re similar to traditional exchange-traded fund (ETFs). However, unlike traditional ETFs, leveraged ETFs aim to provide two or three times the daily performance of the underlying. Leveraged ETFs are able to provide two or three times the daily performance of its underlying index through investments in financial derivatives. Since leveraged ETFs need to maintain a constant leverage factor stated in their prospecti, this type of fund is subject to decay if held longer than the prespecified periods.

Leveraged ETFs could be powerful tools for speculators looking to potentially scale their returns on investments. However, leveraged ETFs should only be considered by highly risk tolerant  traders. Before getting into leveraged ETFs, you should know the inner workings, and why the performance could be very different from the what you may expect. Let’s take a look at some examples.

ProShares Ultra S&P 500

The ProShares Ultra S&P 500 ETF (NYSEARCA: SSO) is one leveraged exchange-traded fund that seeks to provide two times the daily performance of the S&P 500 Index, before fees and expenses. Now, due to the compounding of daily returns, this ETF could deviate significantly from the “expected” two times performance. If you just saw two times the performance of the S&P 500 Index, you could be in a world of pain.

For example, assume you get long SSO at $100, and the S&P 500 Index falls by 2%, therefore you would lose 4% on that day. Assuming you held onto the position, and the S&P 500 Index fell another 2%, you would again lose 4%. Now, let’s say the S&P 500 Index rises 3% on the third day. While the S&P 500 Index would only be down 1% on the week, SSO should be trading at $97.69, down 2.31% from your entry point, rather than being down 2%. Now, if you hold onto the position for an extended period of time, it the returns could be even worse.

Moving on, let’s see how the ProShares Ultra S&P 500 ETF is able to provide speculators with two times the return of the S&P 500 Index on a daily basis. The ETF holds S&P 500 Index swaps from various counterparties, and they are complex financial derivatives and could carry a high degree of risk. The risks associated with swaps include counterparty risk, liquidity risk and correlation risk, as well as leveraged risk. In addition to holding swap contracts on the S&P 500 Index, SSO also holds shares of companies in the S&P 500 Index.

Here’s a look at SSO on the weekly chart:

Source: Investing.com

Now, take a look at the SPDR S&P 500 Index ETF (NYSEARCA: SPY):

Source: Investing.com

Notice how SSO and SPY’s percentage changes significantly different. Compounding of daily returns works both ways. It’s possible to significantly outperform or underperform non-leveraged and non-inverse ETFs tracking the same underlying index.

Let’s take another leveraged S&P 500 ETF from the same issuer.

ProShares UltraPro S&P 500

The ProShares UltraPro S&P 500 ETF (NYSEARCA: UPRO) is similar to SSO, but UPRO seeks to provide daily investment results corresponding to three times the daily performance of the S&P 500 Index. Again, the ProShares UltraPro S&P 500 ETF uses swap contracts to provide leveraged exposure. However, it is not limited to using swaps, it could use other financial derivatives to provide three times leveraged exposure to the S&P 500 Index. Now, there are similar risks embedded here. Since UPRO holds swap contracts, there’s liquidity risk, counterparty risk and correlation risk, just to name a few. Now, the effects of compounding returns could be more pronounced with UPRO due to its three times leverage factor.

Let’s take another look at a hypothetical example. Let’s say you’re long UPRO at $100, and the S&P 500 Index fluctuates 3% up, then 3% down, followed by 3% up, and finally 3% down. Now, you might be thinking, well UPRO didn’t move at all. However, when you actually calculate these returns, UPRO would trade at $98.39, and you would be down 1.61%. That’s compounding returns for you. The takeaway here is to not hold leveraged ETFs for longer than one day.

Final Thoughts

Leveraged ETFs are best set aside for speculative traders who have a high degree of risk tolerance. Now, if you’re a long-term investor or swing trader who holds position for multiple weeks, you would not want to be long ETFs like SSO and UPRO over a prolonged period of time. Your capital could be eroded due to compounding of daily returns, and again, leveraged ETFs are extremely risky. If you know the intricacies of SSO and UPRO and have read through their respective prospecti, and you’re highly risk tolerant, you could allocate a small portion if you’re extremely bearish on the S&P 500 Index. However, keep in mind you should not hold something like SSO and UPRO for a period longer than one day, and you should understand that you could lose more than expected with leveraged ETFs.

Learn how to trade leveraged ETFs HERE!

Author: Jeff Bishop

One of the best traders anywhere, over the past 20 years Jeff’s made multi-millions trading stocks, ETFs, and options. He is renowned as an incredible trader with a deep insight and a sensitive pulse on the markets and the economy. Jeff Bishop is CEO and Co-Founder of RagingBull.com.

Even greater than his prowess as a trader is his skill and passion in teaching others how to trade and rake in profits while managing risk.

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