Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF? — Part 15: World Currencies]

Even with the controversy and greater scrutiny over inverse and leveraged ETFs, the investments are still a great hedging tool. Nevertheless, potential investors should fully understand how they work to efficiently utilize the funds in a tactical portfolio.

Leveraged ETFs try to magnify the daily movements of an underlying asset or index through a double- or triple-multiplier by using derivatives or futures contracts designed to earn a multiple of the return for a given Index. Inverse ETFs also use derivatives in an attempt to achieve a negative, or inverse, multiplier to the direction of the underlying asset or index.

For instance, if the underlying index goes up, a long 2x-leveraged fund will jump twice that amount for that specific trading day. For a short fund, if the index goes up, the fund will mirror the negative performance of the index for that day. The general idea also applies to other inverse and multiples-leveraged ETFs.

Most leveraged funds are designed to provide a daily target so they may limit risk from too much leverage and reduce the risk of losing more than what is in the ETF. It should be noted that inverse and leveraged funds will specify whether or not they rebalance to provide a daily or monthly target.

Additionally, traders should know that inverse and leveraged products are not suitable for long-term buy-and-hold investors as the compounding affects from the rebalances would create divergences from the ETF’s performance to that of the underlying index, especially over periods of high volatility.

Fund sponsors have made it clear in their prospectus notes that leveraged ETFs try to pursue daily leveraged investment goals, and the returns of a fund for a period longer than a full trading day will not translate to a 200% or 300% return of an index for extended periods since the aggregate return of an ETF is based on a series of daily leveraged returns for each trading session as a result of “daily rebalancing”.

Nevertheless,  leverage or inverse ETFs may be appealing for avid day traders. These funds tend to be very liquid and can be used as a hedge for any short-term corrections or upswings. Furthermore, these types of ETFs may be used to capitalize on positive current events that could provide a nice boost to the markets. Leveraged and inverse products also provide the opportunity for daily ETF traders to jump in and make some money on quick market actions or capitalize on pessimistic market news.

For past stories in this series, visit our “What is an ETF?” category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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