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There are a multitude of leveraged strategies aimed at retail investors. Most of these follow the performance of major indices, while others track niche areas of the market like the semiconductor and biotech industries. By choosing the latter, investors hope to capture additional return.
What is leveraged trading?
Leveraged investing lets traders use debt to increase their buying power. With the additional funds, traders often purchase futures and other financial derivatives to speculate on the stock market.
By taking additional risk, traders seek to capture outsized returns.
Also known as margin trading, the strategy can be risky because those bets often become outsized losses when a trade goes sour. Plus, traders need to pay back the borrowed funds along with interest and any transaction fees.
Apart from these factors, traders are on the hook for short-term capital gains taxes if the assets are held in a taxable account.
Leveraged ETFs: What they are and how they work
Most investors use ETFs as a low-cost option to diversify and mimic the performance of a broad index like the S&P 500. So, if the benchmark is up 1 percent, an S&P 500 index fund should also rise about 1 percent.
With leveraged exchange-traded funds (leveraged ETFs), the results are exponentially magnified as financial derivatives react differently to market changes.
For example, when the S&P 500 is up 1 percent, a leveraged ETF tracking the index could rise 2 percent or even 3 percent. It all depends on the magnitude of leverage used and how it connects to the news causing the move.
While that might sound tempting, potential losses can be just as pronounced. Financial derivatives, like other exotic market products, react differently to negative news. Using the hypothetical example above, when the stock market drops 2 percent, a triple-leveraged ETF will plunge around 6 percent, depending on the underlying assets.
It’s worth noting that leveraged ETFs aim to enhance the daily performance of certain market indices. If the stock market goes up 10 percent this year, you can’t get a 20 or 30 percent return by using these leveraged ETFs. For this reason, these funds don’t make sense as long-term holdings and should only be used by short-term traders.
The best leveraged ETFs
With that in mind, here are some of the most popular leveraged ETFs:
ProShares UltraPro Short QQQ (SQQQ)
SQQQ is a highly leveraged ETF, offering three times downside exposure to large-cap, tech-heavy companies in the Nasdaq 100 index. The average daily volume for this ETF is about 118 million shares, making it one of the most popular leveraged funds.
Expense ratio: 0.95 percent
Assets under management: $4.0 billion
ProShares Ultra S&P 500 (SSO)
SSO offers two times daily upside leverage exposure to the Standard & Poors 500 index (S&P 500). The average daily volume for this ETF is about 4 million shares.
Expense ratio: 0.89 percent
Assets under management: $4.4 billion
ProShares UltraPro Short Dow30 (SDOW)
SDOW offers three times downside leverage exposure to the Dow Jones Industrial Average. The average daily volume for this ETF is only about 6 million shares.
Expense ratio: 0.96 percent
Assets under management: $470.4 million
Direxion Daily Small Cap Bull 3X Shares (TNA)
TNA offers three times leveraged upside exposure to small-cap companies in the Russell 2000 index. The average daily volume for this ETF is around 13 million shares.
Expense ratio: 1.09 percent
Assets under management: $1.6 billion
Direxion Daily Small Cap Bear 3X Shares (TZA)
On the flip side, TZA offers three times leveraged downside exposure to small-cap companies in the Russell 2000. The average daily volume for this ETF is around 11 million shares.
Expense ratio: 1.03 percent
Assets under management: $411 million
Direxion Daily Semiconductor Bull 3x Shares (SOXL)
SOXL provides three times leveraged upside exposure to an index of companies involved in developing and manufacturing semiconductors. The average daily volume for this ETF is about 60 million shares.
Expense ratio: 0.94 percent
Assets under management: $7.8 billion
How to buy leveraged ETFs
Leveraged ETFs can be valuable for seasoned traders as increased volatility provides short-term opportunities to get in and out of positions.
There are even leveraged ETFs that allow traders to profit when the market drops. These types of funds are called inverse leveraged ETFs.
Consider the ProShares UltraShort QQQ ETF (QID), which seeks to return two times the opposite performance of the Nasdaq 100 index. So, if the benchmark is down 2 percent, this ETF shouldrise about 4 percent.
During increased periods of market volatility, these types of speculative investments can be lucrative. Hence the reason they exist.
Depending on your financial situation and risk tolerance, there are various strategies for trading leveraged ETFs. Your level of financial knowledge and engagement with your investments are important factors to consider carefully.
Investors should approach leveraged ETFs with prudence. Remember, these types of market instruments are a double-edged sword.
Once you determine your comfort level, decide what percentage of your total account to allocate into these risky assets. Even experienced traders often start small and have an exit strategy. The key is to stick to your plan and know when to close out of a losing position.
What to consider when buying leveraged ETFs
Usually reserved for sophisticated investors, leveraged trading has gained popularity in recent years among retail investors. Lured by the potential of fast money, many have turned to leveraged ETFs as a way to get in on the action.
Leveraged ETFs are a type of investment that aims to magnify returns through financial derivatives and debt. Essentially, they are ETFs on steroids.
There are plenty of ETF screening tools, including those provided by most brokerage firms. While factors like management fees and historical trading performance are important considerations, you should thoroughly review the fund’s prospectus.
A prospectus acts as a legal contract, preventing fund managers from deviating from what they said they would do. By reviewing this information before investing, you can determine whether the fund’s strategy aligns with your investment goals.
As you narrow your options, the key features to consider are:
- Leverage: This metric is qualified by a numeral followed by the letter “x.” So, a fund like the Direxion Daily S&P 500 Bull 3X Shares (SPXL) offers three times the performance of the S&P 500 index. The leveraged expected return is for a single day, not cumulative over time.
- Expense ratios and fees: By default, most ETF providers charge competitive fees. But even at relatively low levels, those costs can add up, so make sure to compare apples-to-apples and read the fine print.
- Trading volume: The more liquid a fund is, the easier it will be to buy and sell. Look at how average trading volume compares to similar ETFs.
- Fund performance: Numbers don’t lie. While doing your research, take a look at a fund’s daily performance. But remember, these funds are not intended as a buy-and-hold strategy.
- Assets under management (AUM): Many investors use this figure as a vote of confidence to assess other investors’ engagement with a particular ETF. Along with AUM figures, it might be helpful to check the longevity of the fund.
- Fund issuer: Brands are powerful. And that’s no different in the ETF space. Some investors feel comfortable only investing in large asset managers, while others see the value in newcomers. Decide what works for you and your financial needs.
Use these criteria as a starting point to do more research. Some investors find it helpful to study the daily performance of leveraged ETFs before committing any money.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.