Navigating Risks of Leveraged, Inverse ETF Play

As the markets wade through heightened volatility, many have capitalized on the wild swings with leveraged and inverse exchange traded funds (ETFs) to juice returns. However, while the strategies may generate lucrative returns, investors should fully understand how these products work and the risks involved.

Leveraged and inverse ETFs utilize derivatives to achieve their exponential or inverse returns. The derivatives include instruments like swap agreements, futures and forward contracts, and put and call options.

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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 in any given day. If the underlying index rises 2% in a day, the leveraged ETF would gain 4%. There are also a number of leveraged ETFs that provide 3x or 300% leverage, which would rise or fall three times as much as the underlying market.

Potential traders should keep in mind that these leveraged ETFs are designed to produce double or triple the performance of the underlying market on a daily basis. Consequently, when investors look at the long-term performance of a typical leveraged ETF, people may notice that the funds do not perfectly reflect their intended strategies.

Related: Popular Short-Term Leveraged/Inverse ETF Bets

For example, the ProShares Ultra S&P 500 ETF (NYSEArca: SSO), which attempts to deliver twice the daily returns of the S&P 500 index, has more or less closely followed its intended 2x multiplier over the shorter term – over the past three months, SSO gained 19.3% as the S&P 500 rose 9.6%.

A strong bull market without long interruptions and relative low volatility helped maintain positive gains in the leveraged ETF. Since the ETFs rebalance on a daily basis, the compounding effect benefits leveraged ETFs in a upward-trending market. In an upward-trending market, compounding can generate longer-term returns that are greater than the sum of the individual daily returns. Similarly, in a downward-trending market, compounding can generate longer-term returns that are less negative than the sum of the individual daily returns.