In the world of financial investments, there are various instruments that traders and investors can utilize to enhance their potential returns. One such instrument is the Leveraged Exchange-Traded Fund (ETF). Leveraged ETFs offer the opportunity to amplify the returns of an underlying index or asset class. However, they also come with their own set of risks and considerations. In this article, we will explore the concept of leveraged ETFs, understand how they work, analyse their benefits and drawbacks, and help you determine if they are worth trading.
What Are Leveraged ETFs?
Leveraged ETFs are a type of exchange-traded fund that aims to provide a multiple (2x or 3x) of the daily returns of an underlying index or asset class. These ETFs utilize financial derivatives and borrowing to achieve their leveraged exposure. Leveraged ETFs are designed for short-term trading strategies and are not intended for long-term investments.
To further illustrate the possible profit and losses of trading leveraged ETFs, let's refer to the NYSE Arca Gold Miners Index ETF that tracks the price of gold miner stocks. Trading the leveraged ETFs of that involves taking a look at Direxion Daily Gold Miners Index Bull 2X Shares (NUGT) and Direxion Daily Gold Miners Index Bear 2X Shares (DUST).
Examples of Leveraged ETFs You Can Find with Us
- INDL - Direxion Daily MSCI India Bull 3X Shares ETF
- NUGT - Direxion Daily Gold Miners Index Bull 2X Shares ETF
- DUST - Direxion Daily Gold Miners Index Bear 2X Shares ETF
- SOXL - Direxion Daily Semiconductors Bull 3X Shares ETF
- YINN - Direxion Daily FTSE China Bull 3X Shares ETF
Understanding Leverage in ETFs
Leverage is a financial term that refers to the use of borrowed funds to magnify the potential returns of an investment. In the context of leveraged ETFs, leverage is achieved by borrowing money or using derivatives such as options and futures contracts. When it comes to the specific mechanics of leveraged ETFs, they typically involve a mix of financial instruments such as swaps, futures contracts, and options to achieve their desired leverage. These ETFs are then typically rebalanced on a daily basis to maintain their stated leverage ratio.
Leveraged ETFs vs. Traditional ETFs
Leveraged ETFs differ from traditional ETFs in terms of their investment objectives, risk profiles, and trading strategies. Traditional ETFs aim to track the performance of an underlying index without the use of leverage. This makes them suitable for long-term investing strategies. Leveraged ETFs, on the other hand, are designed to generate returns that are two or three times greater than that of an underlying index or asset class. They are typically used as short-term trading investments rather than instruments that are suitable for dollar-cost averaging and long-term investing over a prolonged time horizon.
Benefits of Trading Leveraged ETFs
For traders seeking additional leverage while trading, leveraged ETFs offer the following benefits:
- Amplified Returns: Leveraged ETFs offer the potential for amplified returns compared to traditional ETFs or individual stocks. This can sometimes lead to multi-fold returns.
- Diversification: Leveraged ETFs provide exposure to a wide range of asset classes that range from equity to commodities. This allows leverage ETF daytraders to diversify and seek returns when one particular sector is not moving in their favour.
- Short-Term Trading Opportunities: Leveraged ETFs are designed for short-term trading strategies and possibly allow investors to capitalise on short-term market movements through strategies like scalping.
Risks of Trading Leveraged ETFs
Although leveraged ETFs and index funds do provide the likelihood of greater returns, they do come with their own set of risks and drawbacks:
- Volatility: Leveraged ETFs are more volatile than traditional ETFs due to their amplified exposure, making them unsuitable for risk-averse investors who are uncomfortable with magnified losses.
- Leverage Decay: Leveraged ETFs may experience leverage decay or tracking error over time, leading to potential deviations from their intended performance.
- Complexity: Leveraged ETFs can be complex financial instruments, requiring a thorough understanding of their mechanics involved with swaps, options and futures contracts.
Factors to Consider Before Trading Leveraged ETFs
Before trading leveraged ETFs, it is essential to consider the following factors:
- Investment Objectives: Determine if the investment aligns with your financial goals and risk tolerance.
- Market Conditions: Assess the current market conditions and evaluate the potential impact on the underlying asset.
- Leverage Ratio: Understand the leverage ratio of the ETF and how it affects the potential returns and risks.
- Trading Costs: Consider the impact of trading costs, including expense ratios, bid-ask spreads, and commissions.
Common Misconceptions about Leveraged ETFs
From easily obtaining double the returns to dollar-cost averaging into leveraged ETFs, here are the misconceptions newer traders and investors tend to have when considering how leveraged ETFs work:
Leveraged ETFs Are Suitable For Long-Term Investments
Leveraged ETFs are not suitable for long-term investments due to the potential for leverage decay. As such, leveraged ETFs should only be used for short-term trading strategies and not as an alternative to long-term index funds.
Leveraged ETFs Offer Guaranteed Returns
Leveraged ETFs may offer the potential to amplify returns, but they do not guarantee profits or shield traders from losses. It is essential that investors understand the risks associated with leveraged ETFs and trade them responsibly.
The Returns of Leveraged ETFs Can Be Obtained Through Simple Multiplication
Due to the complicated use of derivatives to achieve the desired leverage factor, the relationship between the underlying index's returns and the leveraged ETF's returns is not a simple multiplication. As such, it is essential to understand the mechanics of leveraged ETFs before considering trading them.
Are Leveraged ETFs Worth Trading?
The decision to trade leveraged ETFs depends on various factors, including risk tolerance, investment objectives, and market conditions. It is essential to understand the mechanics of leveraged ETFs, assess their risks and rewards and use them responsibly with proper risk management practices. With that said, leveraged ETFs can be an effective tool in a trader's arsenal when used correctly as they have the possibility of amplifying trading returns when combined with skillsets like technical and fundamental analysis.
Leveraged ETFs offer the potential to amplify returns, but they also come with their own set of risks and considerations. Before trading leveraged ETFs, it is important to understand how they work, evaluate their benefits and drawbacks and ensure that they align with your financial objectives and risk. From gold-related leveraged ETFs to ones covering sectors like China and semiconductors, you can begin your trading journey by signing up with us today.
Disclaimer: CMC Markets is an order execution-only service. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.