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Trading Leveraged ETFs For Max Profits

Leveraged ETFs get some very polarizing opinions in the investor and trading communities.

On one end of the spectrum, they are loved by the adrenaline-chasers looking to bet aggressively for a quick double on their account in short time.

And on the other hand, there is a great deal of hesitation backed by an army of articles written with the warnings of what horrible vehicles leveraged ETFs are.

The good news is there can be a middle ground between the two extreme views, and it can lead to some great trading opportunity so long as you know what you own and respect the risks involved.

Throughout this article, we’ll do our best to get you prepared by discussing what leveraged ETFs are, outlining the risks and benefits, and sharing some tips on how we use them in our trading strategies.

I’ve recorded this article in video format, so if you prefer to sit back and listen, click the play button; otherwise, read on.

What Are Leveraged ETFs?

Taken directly from Investopedia:

A leveraged exchange-traded fund (ETF) is a fund that uses financial derivatives and debt to amplify the returns of an underlying index. These funds aim to keep a constant amount of leverage during the investment time frame, such as a 2:1 or 3:1 ratio.

In plain English, a leveraged ETF simply returns a two or three multiple of the underlying index it’s tracking.

Leveraged ETFs can exist both for the upside of an index (long/bullish) and also for the downside (short/bearish) direction.

For example, let’s take the S&P500 as our index.

If we want to trade the S&P500 using a standard ETF we would trade the SPY.

If we want an ETF that returns 200% of SPY movement, we can trade the SSO, and for 300% movement, we can use UPRO.

If the SPY finishes up 1% on the day then SSO and UPRO will return 2% and 3% respectively (plus or minus a few basis points for slippage).

Here’s a 6-month return profile from stockcharts for each of those ETFs (click to enlarge).

Performance Image - Trading Leveraged ETFs for Max Profits


How Are LEVERAGED ETFS Constructed?

There are lots of articles that go into the weeds answering this, but for the scope of this article, let’s keep it at a high level and summarize it in just a few sentences.

Funds use one or more of the following products to achieve their desired leverage:

Back to our S&P500 example, for the 3x ETF UPRO, the fund could simply invest its cash in owning near-term stock market index future contracts on SPX, to bring its leverage to the desired 300% threshold.

The target exposure is simple. It’s the rebalancing that gets complicated.

Rebalancing is the constant calculations the fund has to do to maintain the target exposure as time passes and the price fluctuates.

The downside of using index futures and options to achieve leverage is that they both decay in value as time passes, which means the funds constantly need to sell, roll, and adjust the contracts they hold.

It’s also in the rebalancing where performance decay and price drift begins to set in, which we’ll talk more in the next section.


What Are The Risks of Trading Leveraged ETFs?

The first risk is the sheer leverage. Remember, these instruments are juicing up returns to double or triple the movement of some underlying instrument.

Seems easy to understand, but this can be especially dangerous if the underlying index suddenly experiences a sharp increase in volatility or some unexpected news event hits in very short order.

It only takes a 3%+ move for your triple leveraged ETFs to be down double digits.

The second type of risk goes back to the construction of the ETFs, specifically the rebalancing part.

Leveraged ETFs decay in value as time passes due to the constant rebalancing and rolling of underlying futures and options contracts.

Volatility Decay In Leveraged ETFs

The third risk is something called volatility decay.

An easy way to understand this is with the classic example of a portfolio that loses 50% of its value in a drawdown.  In order to get back to even, it’s not a simple 50% return, instead, it requires a 100% rally to get back to that high water mark.

Leveraged ETFs are no different.

The values aren’t so extreme, but what you have is lots of micro moves back and forth that causes the ETF to lose precision particularly in choppy market environments.

Finally, It is worth noting, there are some leveraged ETFs that do decay faster than others. The popular leveraged index ETFs like SPXL, TQQQ, and TNA tend to exaggerate returns in both directions. If you’re in a strong bull trend, you may even see these outperform over 3X to the upside. On the flip side, choppy or bearish markets can cause performance to cut deeper than -3X.

Commodity ETFs for example, tend to be much worse than equity ETFs (in all environments) due to the extreme forces of contango.

We’ll spare the math and nitty-gritty details and just look at an example instead (click to enlarge the chart).


Looking at just one year of data on our UCO double leveraged oil ETF (top chart) it managed to return -6.86% despite the underlying futures market it’s attempting to track rallying +42.8%!

UCO should have seen a +85% return in a perfect world, yet it couldn’t even close positive on the year.

If you were trading UCO intraday or for any multi-day swing, you would have gotten more or less the correct return, but when you try and extend out the hold time that long, the decay is just too powerful.

Luckily, the solution to this is simple.

Do not hold [primarily commodity AND INVERSE] leveraged ETFs as investments or long-term trades!

I personally, prefer to keep hold times under 2 weeks.

If you’re planning on holding something for more than a day or swing trade here’s a quick list of things to verify:

  • Compare a historic chart just like we did above of the leveraged ETF versus its underlying.
  • Look up the expense ratio. Leveraged ETFs tend to have much higher fees than regular ETFs.

Okay, now let’s get into the fun stuff.


Benefits of Trading Leveraged ETFs For Max Profits

Leveraged ETFs aren’t all bad!

Used correctly, they’re an efficient use of capital, serve as great hedges when you want to protect a portfolio of longs, and are great for layering on additional broad or targeted exposure.

The tips to trading them are:

  • Have a short enough trade outlook
  • Precise market timing
  • Position sizing

If you have a plan for each, then levered ETFs can be a wonderful tool in the belt.

My Strategy For Trading Leveraged ETFs

The trades I make fall into two categories.

The first are quick multi-day setups that last about 2 to 4 trading days, this is where leveraged ETFs come in, and the second category are longer 2 to 4-week swings on leading stocks.

For the ETFs, notice my outlook is fast, under a week, which means I’m very carefully picking my spots.

I do this, by mostly trading setups that focus on momentum.

Not pullbacks, support buys, or trends, I’m looking for fast breakouts or sharp reversals.

Here’s an example of a quick 3-day reversal trade taken in TQQQ, the triple levered Nasdaq 100:

TQQQ Reversal - Trading Leveraged ETFs For Max Profits

I’m a big fan of taking smaller profit targets into strength with these types of setups.

Here’s another reversal trade taken using ERX the triple leveraged energy bull ETF ERX.

ERX Reversal - Trading Leveraged ETFs For Max Profits

Notice profit was taken on the first meaningful day of follow through and an exit came as soon as we broke below the prior days low.

But we all know trades don’t always work out in our favor, and it’s especially important with leveraged ETFs to honor your stops and move on when the trade moves against you.

Here’s a loss we took in the triple leveraged biotech ETF LABU trying to play a multi-day breakout:

LABU Breakout - Trading Leveraged ETFs for Max Profits

We also use them as hedges to offset long exposure when we want to protect against potential market weakness.

For example, when I have a few longs on that I like for a longer multi-week hold, but the S&P500  breaks some support that I think could continue to spill over, I’ll buy some SPXS.

Instead of selling the longer term names that I still like, I’ll use SPXS to cover my outstanding risk, very similar to going to the options market and buying puts.

If you want to learn more about our actual trading strategy, you can do that here.

My Universe of Liquid Leveraged ETFs

Finally, I’ll leave you with a list of ETFs that I trade on a regular basis.

There are lots out there to choose from, many available on the same index or sector.

Because there are many choices, it’s important to verify two things before trading:

  • Find out exactly what the underlying index it aims to track is
  • Find out the average daily volume

To get you started, here’s a list I’ve put together for myself (as of April 2017) for available liquid leveraged ETFs.

Occasionally names need to be rotated out if volume dries up or an ETF gets delisted.

Non LeveragedBull 3X ETFBear 3X ETF

Trading Leveraged ETFs For Max Profits

Leveraged ETFs can be wonderfully profitable trading vehicles when you treat them responsibly and account for the risks involved up front.

By researching and addressing the downside, you put yourself in a position to maximize the high powered return potential on the upside.

I hope this article has been informative. If you have any comments or questions, feel free to leave them below, or contact me directly.

6 comments on “Trading Leveraged ETFs For Max Profits

  1. 8-10-17, Sabre-rattling at North Korea today, broadmarket indices (except Dow) plunged below 50dma after string of alltime record highs, S&P trading at 23-times, smell an imminent correction.
    Broadmarket without trend right now, no decent swing trades stocks…shopping internet for info trading leveraged ETF’s.
    One sight claims that they have the “Power-Of-God”, some bullshit rock&roll buy-and-hold strategy with 3x ETF’s…I am a devout believer in Our Lord, but He kicked the money-changers out of the temple…saw through that one pretty quick…not to mentioned got burned a few times by the volatility of 3x some years back when I tried a long-short rebalancing strategy for the long term…expensive lesson.
    On your homepage it says “Do not hold leveraged ETF’s as investments or long-term trades”…NO SHIT!
    Soon as I saw that, I knew you were for real…new here, really enjoy your free tutorials, especially the one about Market Breadth.
    Maybe in the future, if some serious “capital-appreciation” comes my way, may consider becoming a member.
    Do you offer Level-2 Book?

    1. Hey Dave, thanks for the comment.

      I like your story of the site you found claiming they have the leveraged ETF holy grail. When I hear someone tell me they stumbled upon a trading strategy like that, I always say, they’re either trying to sell you something expensive or they’re simply very niave, either case, you should probably run away.

      Unfortunately, no material on Level-2. Good luck out there.

  2. Hey, what do you think about shorting a leveraged ETF? This would result in putting the decay factor into the traders favour. I heard somewhere that a trader turned $500K into $12M by shorting the VIX. Perhaps he got blown up last month, but he would have profited from putting the decay on his side. Thanks for your time.

    1. Hi Kelly,

      It’s a great idea in theory, but unfortunately, it’s not that frictionless and clear-cut.

      Finding shares available to sell short is not easy in leveraged ETFs and the borrow costs are quite expensive.

      The XIV trade that many traders were catching onto (shorting volatility) worked amazingly for years, until of course, it blew up.

      There are probably some fairly complex or at least time intensive options strategies you could implement for a synthetic VIX short, but it would require some planning and research.

      Good luck!

  3. Great article, full of valuable info. Thanks! I’m having trouble when the market turns on me, wondering where you set your stops and do you ever adjust them if a trade doens’t go your way.

    1. Hey Patrick,

      Thanks for the comment and question. There are a few different schools of thought out there about stop-loss placement so here’s my advice. A stop loss should always be placed at the point at which the trade thesis/rationale for entering the trade has been invalidated.

      So for instance, if you are putting on a trade because a stock is breaking out above last weeks highs then if the stock starts dropping back meaningfully below those highs, you should no longer stick around in that trade. There’s going to be some wiggle room on how tight you want to make that stop, but my suggestion is not to overthink it. Keep the broad idea in mind of looking for the point or area at which your trade thesis is invalided and go from there.

      Using tight stops will always leave you stopped out more frequently, but the benefit is you get a great reward to risk when the trade works in your favor. On the flip side, wider stops will allow you to tolerate the noise and not get stopped out as much, but finding consistent huge winners relative to the risk won’t happen as often.

      Hope that helps, good luck!

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