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Leveraged ETFs: How They Work, Volatility Decay, And Strategy

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Leveraged ETF strategy and volatility

When it comes to investing, things can get confusing quickly due to how many strategies and tools are available. This can make the process pretty hard for beginners, which can easily give up and choose not to invest. If you are reading this guide, chances are you have found yourself in a similar situation. We want to teach you how leveraged ETFs work.

The good news is that you are on the right track. When it comes to investing, doing your research is half of the work. However, we want to start reviewing the basics. Let’s get started! Once you are done with this guide, you will have a clear idea of how leveraged ETFs work and make the best use of them.

What Are Exchange Traded Funds (ETF)?

Exchange Traded Funds (ETFs) are one of the most popular investment tools due to how much flexibility it provides. An ETF is a type of security, a tradable financial asset. However, a better way to think about them is as a package of securities instead of security itself.

This is because ETFs commonly track the performance of multiple securities, which means you are making multiple investments. An ETF will usually track an index, industry, or arbitrary assets, most commonly stocks. As experts usually create these combinations of stocks, they can be used by beginners very easily.

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In addition to how easily it can be acquired, ETFs offer many other benefits. These include low expense ratios and reduced fees due to how they are traded. If you were to acquire and transact with the individual stocks, you would be paying way more money in expenses.

There are several types of ETFs you can invest in. The most popular are:

  • Bond ETFs: This type of ETF will provide you with regular income resulting from the investment in bonds. These can include corporate or government bonds, which means they tend to be a bit less volatile than other ETFs.
  • Stock ETFs: These ETFs will track the performance of several stocks, which you can choose based on an index, industry, or sector. This allows you to diversify your portfolio by investing in multiple players in an industry, which makes them a great hedge method.
  • Commodity ETFs: Another popular choice, these ETFs will expose you to commodities like precious metals, oil, jewels, etc.          
  • Crypto ETFs: As the name suggests, these ETFs allow you to invest in multiple cryptocurrencies simultaneously. This type of ETF has gained popularity over the past years as the crypto ecosystem grows.

In addition to these types of ETFs, others include other financial tools to provide additional functionality. This brings us to the topic of this guide: Leverage Exchange Traded Funds.

How Are Leveraged Exchange Traded Funds Different?

Leveraged Exchange Traded Funds (Leveraged ETF) are similar to standard ETFs in that they track several securities simultaneously. However, while ETFs track the securities on a 1:1 ratio, Leveraged ETFs tend to leverage your exposure to the securities.

When buying or selling an asset, a portion of the price is paid by yourself, while a lender pays the other. This allows you to use the Leveraged ETF to invest in security using a 2:1 ratio or higher without paying higher money.

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Now, it is important to note two important things about Leveraged ETFs: They have the potential to increase your gains if the investment is successful… But the opposite is also true. This means that they effectively are a sword of Damocles.

However, if used correctly, Leveraged ETFs can be extremely useful financial tools for any investor. It is just a matter of knowing how to use them!

How Does Leverage Work?

Leverage is not a financial instrument unique to ETFs as it is also widely used in the world of stocks and crypto. There are many methods in which leverage can be acquired, but it traditionally consists of derivatives.

The most commonly used derivatives are options and futures contracts. While this is not the topic of this guide, all you need to know is that these are contracts in the long term. Options give you the option to buy and sell stock at a determined price later. Futures contracts work in the same way, but instead of the option, they are obligated to do so.

Who Assumes The Risk When Using Leveraged ETFs?

Investing implies risks due to the possibility of an asset’s value going up or down. Now, when someone is lending you money to invest… How do they deal with the risk?

Well, while you will be borrowing funds from a lender to use Leveraged ETFs, all of the risks will be assumed by yourself. You see, when using leverage in any trading, you will typically be leaving them as collateral.

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If the collateral value drops too much, it will be liquidated if you fail to add money to cover the losses. This means that there is no way for the lender to lose money when you use leveraged ETFs.

If you are doing well, you can sell the Leveraged ETF, pay the money you borrowed plus the interest, and keep the profit! This takes us to the next topic. Let’s take a look at the costs associated with Leveraged ETFs.

What Are The Costs Associated With Leveraged ETFs?

Using Leveraged ETFs comes with many benefits, but it also results in additional costs. After all, they involve additional logistic challenges when transacting with them.

When using Leveraged ETFs, you will have to pay the standard management and transaction fees, as well as interest. Management fees can vary but will typically be around 1% of the fund’s assets every year, which the fund’s management company uses to support its operations.

costs

Transaction fees will be charged when transacting with the Leveraged ETFs, which means you will need to consider them when entering or exiting a position. These fees can be harder to determine than interest and management fees.

You will also need to pay interest on the money you borrow when using them, which can vary depending on the Leveraged ETFs and the platform.

What Is Volatility Decay And Why Does It Matter?

One of the most important concepts you need to be aware of when using Leveraged ETFs is “Volatility Decay”. This concept is why you should only consider leveraged ETFs a means of short-term trading… At least, according to most experts.

The process by which a leveraged ETF loses performance over time is known as Volatility Decay. This is the result of the amplification that leveraging brings to the table.

volatility

Volatility Decay means that holding a leveraged ETF for the long term will be negative in virtually all scenarios. This is not only due to the expense ratio but also due to the amplification of losses. While the math can be a bit complex, the fact is that traditional ETFs will perform better in the long term when compared to Leveraged ETFs.

When investing while using any leveraged instrument, you must always consider that the amplification of losses is more significant than earnings. For this reason, long-term investing and leverage are not great ideas.

Benefits And Drawbacks of Leveraged ETFs

There are no perfect strategies or instruments to ensure you will always profit when it comes to investing. Bigger rewards will always mean bigger risks, which is also the case with leveraged ETFs. As such, before jumping into the opportunity of using leveraged ETFs, you should seriously consider the benefits and drawbacks of doing so.

What Are The Benefits Of Using Leveraged ETFs?

Many benefits come with leveraged ETFs, which is why they have become such a popular financial instrument. Some of these benefits include:

  • Potential for higher daily returns by allowing you to take a position you wouldn’t be able to otherwise.
  • It is a great hedge tool against potential losses.
  • Provides a lot of flexibility when it comes to investing.
  • You gain access to a wide variety of securities with minimal fees.
  • There is a chance for your gains to exceed the index or industry tracked by the ETF.

What Are The Drawbacks Of Using Leveraged ETFs?

As we said before, some risks need to be considered when using leveraged ETFs. While this tool will provide you with the chance to generate more gain… It would help if you always considered the worst-case scenario.

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If that is a risk you can accept, this instrument might be right for you. Let’s take a look at the drawbacks of Leveraged ETFs:

  • Potential for higher losses exceeding the tracked industry or index.
  • Higher fees and expense ratios than traditional ETFs.
  • The use of derivatives can result in slight errors in tracking the assets they represent.
  • Increased risks over the long term make them less friendly for new investors.

Conclusion

As you can see, leveraged ETFs are an investment tool that can open many doors for investors. However, their complexity can make them difficult to understand at first. For this reason, we recommend you make sure you understand the conditions of any leveraged ETF before investing in it.

A common error many investors make is to keep their position open in the long term once they generate profit. As we explained before, volatility decay can make this strategy a disaster. For this reason, this is the most important thing you should keep in mind.

If you consider investing in ETFs, leveraged or not, we recommend you check our Investing section. We have looked at and analyzed some of the most popular ETFs, so you don’t have to. Good luck with your investing!

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