As the markets wade through heightened volatility, many have capitalized on the wild swings with leveraged and inverse exchange traded funds to juice returns.
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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.
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.
For example, the ProShares Ultra S&P 500 ETF (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.
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On the other hand, in times of increased volatility, leveraged ETF returns can fall behind their intended 2x or 3x strategies. Over the long-term or during periods of intense volatility, compounding can generate longer-term returns that are less than the sum of the individual daily returns. For example, SSO returned an average 19.7% over the past five years while the S&P 500 returned an average 11.6%.
Currently, the Chinese A-Shares market, oil swings and its effect on the energy sector, a potential Federal Reserve rate hike ahead and ongoing concerns in Europe, notably from Russia and Greece, have all contributed to short-term volatility.
Nevertheless, traders have utilized leveraged and inverse ETFs to capture areas of interest in a tactical portfolio when political or event-driven decisions may affect a market over the short-term. For instance, the ProShares UltraShort S&P500 ETF (SDS), which tries to reflect the -2x or -200% daily performance of the S&P 500, and ProShares UltraPro Short S&P 500 ETF (SPXU), which also takes the -300% daily performance of the S&P 500, have grown in popularity as a hedge against the so-called most hated bull market ever.
The heightened volatility may also help support gold prices and further bolster the mining sector. For instance, the Direxion Daily Gold Miners Bull 2x Shares ETF (NUGT) and Direxion Daily Junior Gold Miners Index Bull 3x Shares (JNUG) have been popular long bets among gold ETF traders.
While these types of leveraged and inverse ETFs may help traders capitalize on short-term moves, investors should be aware of the risks and potential divergence between these geared products and their underlying assets over the long haul and during periods of heightened volatility.
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