Traders previously had to utilize options or futures contracts to gain leveraged returns in the markets. Leveraged exchange traded funds that provide geared exposure to underlying markets have simplified the task, but investors need to thoroughly understand how the ETFs work and the risks involved.
To start off, leveraged ETFs are securities that trade on an exchange and can be bought and sold throughout the day, like a regular stock, writes Mark P. Cussen for Investopedia.
However, unlike traditional index ETFs, leveraged funds utilize derivatives to achieve their exponential returns. The derivatives include instruments like swap agreements, futures and forward contracts, and put and call options.
For instance, a double, 2x or 200% leveraged ETF’s price would increase or decrease twice as much as the price of the underlying non-leveraged market or index. If the underlying index rises 2% in a day, the leveraged ETF would gain 4%.
Additionally, there are a number of leveraged ETFs offering triple or 300% leverage, which would rise or fall three times as much as the underlying market. Alternatively, there are also leveraged inverse ETFs that move in the opposite direction to their benchmarks – the inverse ETFs would fall in price at its specified exponential rate when the benchmark rises and vice versa.
Leveraged ETFs that move exponentially to the benchmark are considered long or bullish funds while those that move inversely are called short or bearish products.