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, discuss what leveraged ETFs are, the risks and benefits of trading them, and 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).

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:

• Near-term index futures
• Near-term index options
• Equity swaps

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. Leveraged ETFs do very well tracking 200% or 300% their benchmark on any single individual trading day — it’s the overnight and next day action where performance can begin to drift.

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.

Leveraged ETFs updated 2020 example

Here’s an updated 2020 example of where things can break down and go wrong with leveraged ETFs. Given the sharp coronavirus bear market we saw in the first quarter and then equally as sharp v-shape recovery, here’s how the performance stacks up in the Nadsaq 100 and triple leveraged Nasdaq 100:

Notice the $QQQs are up 37.87% and the TQQQ (3x etf) is up 81.09%.

An 81% return is obviously amazing if you managed to hold on and capture that rally, however it’s not a 3X gain. 3 times 37.87 is 113.61 which is meaningfully more than the 81% the TQQQ has returned.

This means holders of TQQQ would have captured all of the downside movement (risks) and only part of the upside.

Not all leveraged ETFs are created equal

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 to multiple weeks and months, 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
• Brush up on your market timing
• Double check your position sizing

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

My strategy for trading leveraged ETFs

Back when I was doing a lot more discretionary trading, the trades I made fell into two categories.

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

For the ETFs, my outlook was 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:

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.

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 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:

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

For example, when we had a few longs on that we liked for a longer multi-week hold, but the S&P500 broke some support that could continue lower, we would buy some SPXS.

Instead of selling the longer term positions that we like, we would use SPXS to cover our outstanding risk, very similar to going to the options market and buying puts.

In the current quantitative trading system we trade we also use leveraged ETFs during healthy market environments and during specific times. You can learn more about that strategy 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 and 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
• 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.

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 I would love to read them below in the comments section.