What is a Leveraged ETF & How Does it Work?

Leveraged exchange-traded funds (ETFs) are a type of financial product designed to amplify the returns of an underlying index or asset. Unlike traditional ETFs, which track the performance of an index in a one-to-one ratio, leveraged ETFs are designed to provide magnified exposure to price changes on a daily basis. That means they can be highly volatile, as they aim to magnify both the gains and losses of the underlying asset. They are primarily used for short-term trading, as their performance can diverge significantly from the underlying index over longer periods due to the compounding of daily returns. Leveraged ETFs may not be suitable for buy-and-hold investors due to this characteristic.

In order to achieve a multiple of the daily performance of a specific benchmark, leveraged ETFs typically utilize financial derivatives, such as futures contracts or swaps. For example, a 2x leveraged ETF aims to deliver twice the daily return of the underlying index, while a 3x leveraged ETF seeks to deliver three times the return. These products have gained popularity for their ability to deliver enhanced returns, but they come with heightened risk. Their leveraged nature means they can deliver substantial rewards in a short amount of time, but they can also lead to significant losses, particularly in volatile or trending markets. As a result, investors need to carefully consider their risk appetite and trading strategy before using leveraged ETFs, understanding that their high volatility and potential for loss make them more appropriate for experienced traders rather than long-term investors.

Leveraged ETFs aim to magnify the daily returns of an underlying asset or index by using financial derivatives such as futures contracts, options, and swaps. These instruments enable the fund to amplify the price movements of the benchmark index by a fixed multiple, often 2x or 3x. For example, a 2x leveraged ETF aims to deliver twice the daily performance of the index, and a 3x leveraged ETF targets three times the daily performance. The key to understanding how these funds function is their focus on daily rebalancing, ensuring the leverage is maintained consistently.

Each day, a leveraged ETF adjusts its position to reflect the desired multiple of the benchmark's daily return. This means that if the underlying index increases by 1% on a given day, a 2x leveraged ETF aims to increase by 2%, and if the index declines by 1%, the ETF aims to decrease by 2%. However, this magnified return is only intended for daily performance. Because the ETF rebalances daily, its performance over time can diverge significantly from the underlying index due to the compounding effect of daily returns. This is where leveraged ETFs can become tricky, especially over longer periods.

For example, consider an investor holding a 2x leveraged ETF that tracks an index. On Day 1, the index increases by 5%, so the ETF aims to increase by 10% (2x the 5% gain). On Day 2, the index decreases by 5%. While one might expect the ETF to simply decrease by 10% (2x the 5% loss), that’s not how it works. Since the ETF has already increased in value, the 5% loss is applied to the new, higher value. As a result, the ETF will experience a larger loss than the expected 10%. This compounding effect highlights why leveraged ETFs are most effective for short-term trading, as their performance can become distorted over longer periods due to daily rebalancing.

Leveraged ETFs come in various forms, each designed to meet specific investment goals and strategies. The most common types are bullish leveraged ETFs, bearish leveraged ETFs, and inverse leveraged ETFs. Each type uses leverage to either amplify the returns of a market's upward or downward movement. These ETFs are typically designed for short-term trading due to the volatility and potential for divergence from the underlying index over longer periods. More details on these types of leveraged ETFs are highlighted below.

Bullish Leveraged ETFs

• Description: Bullish leveraged ETFs aim to provide a multiple of the daily return of an index or asset that tracks upward movements. These ETFs are used by investors who expect the underlying asset to rise in value. A typical example would be a 2x or 3x leveraged ETF that seeks to deliver 2 or 3 times the daily return of an index, such as the S&P 500.

• Example: The ProShares Ultra S&P500 (SSO) is a 2x leveraged ETF that tracks the S&P 500 index. If the S&P 500 increases by 1% on a given day, the SSO ETF aims to increase by 2%. These funds are used by traders who believe the market will experience upward momentum over short periods.

Bearish Leveraged ETFs

• Description: Bearish leveraged ETFs aim to provide a multiple of the daily return of an index, but they amplify downward movements. These ETFs are used by investors who expect the underlying asset to decrease in value. These funds can offer returns when the market falls, typically targeting 2x or 3x the daily inverse movement.

• Example: The ProShares UltraShort S&P500 (SDS) is a 2x leveraged inverse ETF that tracks the opposite performance of the S&P 500. If the S&P 500 declines by 1%, the SDS ETF would aim to increase by 2%. These funds are often utilized by traders who believe that the market will experience a downturn, or want to hedge against potential losses.

Inverse Leveraged ETFs

• Description: Inverse leveraged ETFs aim to deliver the opposite of the daily return of a benchmark index, often with leverage. These funds seek to amplify the inverse of the market’s movements, and like bearish leveraged ETFs, they benefit from price declines. They are primarily used for hedging or short-term speculation in falling markets.

• Example: The Direxion Daily S&P 500 Bear 3X Shares (SPXS) is a 3x inverse leveraged ETF that seeks to deliver three times the opposite of the daily performance of the S&P 500. If the index falls by 1%, the SPXS ETF aims to rise by 3%. These funds are often used by traders who believe the market will experience significant declines, or by those looking to profit from short-term downturns.

A single stock leveraged ETF is a type of leveraged ETF that aims to amplify the daily price movements of a single underlying stock rather than a broader market index. Similar to traditional leveraged ETFs, these products use financial derivatives to achieve a multiple of the daily return of the stock, typically in the range of 2x or 3x. A single stock leveraged ETF can provide investors with the ability to gain magnified exposure to the price movements of a specific stock without directly owning the stock itself. For example, if an investor expects a particular stock to experience significant price movement, they may use a single stock leveraged ETF to potentially magnify their gains.

These ETFs are designed to reflect the daily performance of the underlying stock, meaning that if the stock increases by a certain percentage, the leveraged ETF will aim to deliver a multiple of that return, and vice versa if the stock decreases. However, as with other leveraged ETFs, the performance of these products can diverge from the underlying stock over longer periods due to the daily compounding effect. Single stock leveraged ETFs are typically used for short-term trading, especially in volatile or trending stocks, as their amplified returns come with higher risk. They are also used by traders who want to profit from short-term price movements without directly purchasing the stock or managing a position in options or futures.

Popular examples of single stock leveraged ETFs include the Direxion Daily Nvidia Bull 3X Shares (NVDA), which aims to deliver three times the daily performance of Nvidia stock, and the ProShares UltraPro Tesla (TSLA), which seeks to deliver three times the daily performance of Tesla stock. These products offer investors a way to make highly leveraged bets on the performance of some of the most popular and volatile stocks in the market. As with all leveraged products, the high risk and potential for significant losses should be carefully considered before using single stock leveraged ETFs.

Let’s consider a hypothetical example using the Direxion Daily Nvidia Bull 3X Shares (NVDA), a 3x leveraged ETF that tracks Nvidia stock. Suppose the investor buys $1,000 worth of this ETF, expecting Nvidia’s stock to increase in value over the next few days.

When considering leveraged ETFs, it's important to weigh the pros and cons to understand whether these funds align with your investment strategy and risk tolerance. Leveraged ETFs offer the potential for amplified returns, but they also come with significant risks, making them potentially a better fit for short-term trading strategies, as opposed to long-term investing. Below, we explore the key advantages and disadvantages of leveraged ETFs to help investors make more informed decisions when evaluating these products. 

One of the primary advantages of leveraged ETFs is their ability to magnify exposure to an underlying asset or index. These funds use financial derivatives to deliver a multiple of the daily return of an index, typically 2x or 3x, which means investors can potentially see larger gains during strong market moves. Leveraged ETFs can be especially useful in volatile markets, where traders seek to capitalize on short-term price movements without needing to directly own the underlying asset. Additionally, leveraged ETFs can provide easy access to leveraged positions in individual stocks or sectors without the need to manage options, futures, or margin accounts.

However, this potential for amplified returns comes with considerable risks. The most significant downside is the heightened volatility and the risk of magnified losses. Because leveraged ETFs rebalance daily to maintain their leverage, their performance can deviate substantially from the performance of the underlying index over longer periods, especially in choppy or sideways markets. Compounding daily returns can lead to larger losses if the market moves unfavorably, and this can make leveraged ETFs potentially less suitable for long-term investors. Even with an initial gain, the volatility inherent in leveraged ETFs can erode profits quickly.

Another drawback is the cost. Leveraged ETFs tend to have higher management fees due to the complexity of their strategies, and the use of derivatives to maintain leverage can add additional costs. These expenses can accumulate over time, potentially reducing overall returns. Furthermore, leveraged ETFs are highly sensitive to market movements, meaning that even small adverse shifts in the market can lead to significant losses. As a result, investors should be cautious about using leveraged ETFs unless they have a clear understanding of the risks and are prepared to accept the uncertainty (and potential capital losses) associated with trading these products.