The Curious Case of Leveraged ETFs

This is a topic I’ve been dying to cover because these are super cool financial products that, if well understood, allow you to bet on pretty much anything in the macroeconomic world, and make a pretty penny doing it too. Let me introduce, Inverse and Leveraged ETFs.

Want to bet on interest rates changing or staying the same through FOMC meetings?

I&L ETFs.

Think the Peso is going to skyrocket after the election?

I&L ETFs.

Thought that Brexit was going to happen but didn’t know how to make money on it?

I&L ETFs.

These tools let you make bets (otherwise known as purely directional trades, the riskiest kinds) on things in the ultra-short term. They don’t do well over a long time because of how they’re built, but right now, all you should be thinking about is snap events that you think you know the outcome to, or something may have already happened that you think will set off a chain reaction resulting in one area of the economy doing very well. The lure of leveraged ETFs are their speed and volatility. For instance, if you thought that the financial sector was going to do very well because congress has been talking about repealing a restrictive part of legislature that would make financials more profitable, you could just buy a bunch of bank stocks and been happy with your few percentage points and move on if congress actually passed the repeal. Remember though; you are only betting on the congressional outcome, not on a long-term trend. Leveraged ETFs allow you to make two or three times what those bank stocks would have made while only risking the same amount of capital.

Before we go deeper, I’m assuming that you know what an ETF is. If not, check out the link.

A leveraged ETF is an exchange traded fund that uses leverage to magnify returns, but remember; that means positive or negative returns. This is a ridiculously sharp double edged sword.

So, let’s say you want to make the above financial sector bet. Using an ETF, you could purchase XLF and hold it until the price rises. Or, you could purchase something like FAS for instance, an ETF that is made by a company called Direxion. This ETF produces about three times whatever the regular financial ETF does. There are leveraged ETFs for so many different parts of the economy. They usually come in pairs too, which is where Inverse ETFs come in.

You may often see Long or Short or possibly Bull and Bear in the title of the ETF. A Long and a Bull are the same thing, and they perform well when the underlying bet does well. So if you believe that all of the companies in the financial sector are going to do well, the Bull/Long ETF will do very well (triple or double well). Conversely, the Bear/Short ETF will do the opposite of whatever the Bull/Long will do. If you think the financial sector is going to tank, then you can purchase a Bear or Short ETF and make quite a bit of money that way.

il-etf

You can see above how these two move completely opposite of each other, both of these track gold three times over. One cool aspect; these ETFs effectively allow you to short stocks if you don’t already have that option through your brokerage (Hey Robinhood, how’s it going?).

These ETFs do what they do in a myriad of ways, but the most common way is to purchase option contracts, so in effect you are buying a derivative when you buy an I&L ETF. Now whenever you hear the word “derivative”, the word “risk” should also probably jump into your head. These are very risky funds. There will be an article out soon that provides a basic explanation of how options work, but their risk profiles are very unique. This is important to understand because understanding that is how you understand that you shouldn’t hold these things for very long. So, you have a bunch of option contracts that expire over time. The movement and value of the underlying option contracts change as the underlying asset (the asset that the option contracts are reliant on) changes. Very specific and complicated holdings of option contracts allow a fund to match whatever another fund does two or three times over, but the problem is you must buy more of these contracts when the current contracts expire. This costs money, your money.

uvxy

Above is one of my favorite examples of what is called contango, or the idea that these contracts will cost your fund quite a bit of money. UVXY focuses on the volatility index, otherwise known as VIX. The way they determine VIX is a really interesting discussion all in itself, but we’ll get to that in a future article. Notice how UVXY is currently trading at $20.33 but at its peak one share would have been with over $1.4 million. This is not to say that at some point you could have purchased a share of UVXY for $1.4 million, instead this huge price is the result of splitting the equity into more shares once the current share price becomes incredibly small. What this does mean is that you have effectively lost 100% of this position if you bought this in 2012, and not because what this ETF tracked fell in value, but because the cost of tracking ate away at your value. 

The I&L ETFs use the value of the fund itself to purchase more option contracts, and that means that the value of these types of financial products will decay. This  also means that there is a constant headwind working against the value of your I&L ETF, so you need to get in and out of your positions relatively quickly. The fact that there are pairs of these allows for complex trading strategies that hedge funds and other risky investors are probably taking advantage of.

There is quite a bit of debate about how much of the underlying fund movement that these things capture anyway. Since their value is based on various and complex option contracts, there can be slight deviations between what the I&L ETFs return and what happens to the underlying fund.

Also, if you’re curious, here’s how UVXY did since Tuesday:

uvxy3day

Yeah, you read that right, 22%.

This was probably one of the riskiest ways out there to make 22%, but at least it’s possible. As always, be very careful and do your research, but there aren’t a lot of ways to get huge returns like this in the regular market. Goodluck out there!

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