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ETFs have some advantages over other forms of leveraged trading. Here's why.
Using leverage in investment
The prospect of large gains for a small outlay is investing nirvana. Even the most conservative of investors would love to find that one investment that generates many multiples of its initial sum cost. This is the lure of leveraged trading: it gives outsized exposure for a small upfront sum.
This has real advantages: investors don’t have to tie up as much capital to get the exposure they want or liquidate assets elsewhere to fund their positions. They can back their positions with real conviction, meaning time spent on research goes further.
However, leverage needs to be handled with care. An investor’s hunch many be right and they may make many times their initial investment, but it can also be a quick way to lose cash. As such, investors may need to put parameters around their trading positions, based on how much they can reasonably afford to lose.
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What is a Leveraged ETF?
Leveraged exchange-traded funds (ETF) use financial derivatives and debt to magnify the returns from an underlying index or asset. Most ETFs deliver the performance of an index on a one-to-one basis. Leveraged ETFs, in contrast, may raise that to 2:1 or 3:1. That means that if the underlying asset goes up 10%, the investor gets 20%, but the same is true on the downside.
Leveraged ETFs are available for most indexes, such as the S&P 500 or Nasdaq 100 Index. They are also available on commodities and currencies. It is also possible to get leveraged ETFs on market volatility – the Vix index or ‘fear’ gauge.
There are also leveraged inverse ETFs. Inverse ETFs make money when the index or asset is falling and leveraged inverse ETFs magnify those gains. They are useful when an investor is strongly negative on the index or asset. A leveraged inverse S&P 500 ETF, for example, would have made a lot of money in March when stock markets lost around a third of their value. However, it would have struggled as equity markets rebounded.
Potential for gains (and losses)
If the underlying asset goes in an investor’s favour, they can make many times their money. Taking the example of a position with 3:1 leverage: if an investor wants £30,000 worth of exposure, they will make an upfront investment of £10,000 in a 3x leveraged ETF.
If the index rises 25%, the trader makes £10,000 x 75%, leaving them with £17,500. Had they been in a normal ETF, they would have had to put in £30,000 upfront to make the same £7,500 return. However, the opposite is also true. If the index falls 25%, the trader loses 75% of his initial investment – leaving him with just £2,500. If they had put £10,000 in normal ETF, they would still have had £7,500.
How does this compare to margin trading?
For margin trading, the potential gains are far greater, as are the potential losses. If an investor wants the same £30,000 worth of exposure, with a margin level of 5% they will only have to make an initial investment of £1,500. If the current share price is £100, they are holding the equivalent of 300 shares.
If those shares rise to £150, the trader makes £50 x 300 or £15,000 – ten times their original investment. However, had the trade gone against them, their losses could have been much more severe. If the share price for the company fell to £50, the investor would have lost £15,000 and would have to find another £13,500. If they decided to keep the position open, the broker may ask for further margin payments.
Why ETFs over other leveraged options?
There are other options for investors who like to super-charge their investments. Investors can use contracts for differences, for example. ETFs have a number of advantages over other forms of leveraged trading:
- Investors can’t lose more than they put in. With contracts for differences, investors can lose many multiples of their initial investment if the trade goes against them. With leveraged ETFs, an investor can lose all their initial investment, but no more. As such, it can be a good starting point for more sophisticated leveraged trading strategies.
- There are no margin requirements. With other forms of leveraged trading, investors need to put up an initial amount (known as margin). Margin requirements will vary from broker to broker and from asset class to asset class but will typically be less than 10% of the overall exposure.
If a position starts losing money, an investor may be required to top up these margin payments. Equally, the broker may wind up the trade if the margin call exceeds a person’s available funds or sell other positions they hold. With ETFs, there are no margin requirements.
- They will be less volatile. Anyone who introduces leverage into their investments must be prepared for a more volatile ride. However, leveraged ETFs generally behave in a more predictable way than other forms of leveraged trading, making it easier to keep track of the associated risks.
How does the leverage work?
Leveraged ETFs will typically use derivatives to achieve the extra exposure to a particular index or asset. These may be index futures, equity swaps, or index options. These derivatives have a cost and therefore leveraged ETFs tend to be more expensive than normal ETFs. A typical expense ratio may be 0.5% rather than 0.1%. A leveraged index fund will also need to include cash invested in short-term securities to meet any financial obligations that arise from losses on the derivatives.
Key risks for trading leveraged ETFs
Leveraged ETFs are more complex than normal ETFs. The use of derivatives invariably brings in additional risks, such as counterparty risks for the providers of the derivatives and collateral risks should the derivatives provider go bust.
As it stands many of these ETFs are small and expensive relative to other ETFs. They tend to be used by traders rather than investors, which means they don’t have the widespread appeal that drives assets towards mainstream ETFs. This means dealing spreads can be wider and they are less liquid than conventional ETFs. There is also less choice, with leveraged ETFs only available on mainstream equity indices, commodities and currency pairs.
Leveraged trading requires an appetite for risk, but leveraged ETFs can be a gateway in to more sophisticated leveraged trading strategies. Because an investor cannot lose more than their initial investment, they can use leveraged ETFs to hone their trading skills and get to know the market before moving onto to higher risk/higher reward options. It can help investors develop a trading style and understand their strengths and weaknesses.
Leveraged ETFs offer an exciting means to magnify your returns or take high conviction positions in certain assets. This can deliver higher returns for a small upfront cost. However, they always need to be employed with care – losses are magnified in the same way as gains. There is always the potential for unexpected events to derail even the most well-planned trading strategy – the Covid-19 outbreak is a good example. Investors need to understand how much they can afford to lose as well as looking at how much they might make.
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