4 Things To Know Before Trading A Leveraged ETF

Markets Benzinga

U.S. ETFs are on pace to have record inflows in 2017. That includes funds dedicated to equities, fixed income, and commodities.

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And it's easy to see why. With the S&P 500 up 9 percent this year (through 7/20/17) , investors are throwing their money at anything and everything to get a piece of the rally. The diversification of ETFs makes that easier.

This has especially been the case for traders of leveraged and inverse ETFs. In the last three years some of the top leveraged ETFs like FAS, SPXL, and TNA have all more than doubled.

But that's misleading. Leveraged ETFs are, by design, meant for short, intraday trades and not meant to be held overnight. Here are a few tips to trading these vehicles. ETFs.

1. Leveraged ETFs start each day with a clean slate.

Leveraged ETFs are built to reset every day, meaning theyre rebalanced daily. This means the instruments and contracts that make up the ETF are going to change every day.

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These are inherently volatile instruments, yesbut thats how leveraged ETFs deliver the results they do. Traders new to the leveraged ETF trade need to keep that in mind.

2. Keep an eye on volume and liquidity

Because these instruments are short-term vehicles only, you need to be assured that you can get in and out quickly. A leveraged ETF with heavy trading action is more ideal than one without.

3. Leveraged ETFs perform best in trending environments

Anytime the market is in a low volatile, trending market (like, say, right now) leveraged ETFs will perform better than they would in a sideways market. This is because leveraged or inverse ETFs will magnify the returns of whatever the trend is. But its important to note that these are still vehicles that should not be held overnight.

4. Leveraged ETF pairs wont be exact

Many leveraged ETFs exist in pairs, meaning theres a bullish and bearish version. But a 3x bull ETF and 3x bear fund wont necessarily be mirrors of each other. For example look at the Direxion Daily S&P Biotech Bull 3X Shares (LABU) and Direxion Daily S&P Biotech Bear 3X Shares (LABD) in 2017. LABU is up nearly 130 percent, while LABD is down only 69 percent.

What gives? Well, the short answer is daily rebalancing. Because these funds use swaps and other financial derivatives to maintain their leveraged exposure over the course of a single day, their long-term performance will inevitably diverge.

Disclaimers for the funds mentioned above can be found here. Regulatory filings can be found here.

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