Why Leveraged ETFs Are Not for the Nervous Trader
With leveraged ETFs, you can make more money, faster. But you can also lose more money, also faster.
As with any and all investment choices, the question of risk should be at the top of your decision tree. If the risk is too great, look elsewhere. If the risk is acceptable, seek ways to mitigate or hedge it.
When it comes to leveraged ETFs, the market is easily misunderstood and its risk may easily be ignored or forgotten. Many investors and traders are attracted to the potentially rapid profits possible with 2x or 3x products. But they easily forget that losses accumulate just as quickly. Risk with leveraged ETFs comes in the form of acceleration applied to both profits and losses, as well as higher margin requirements. Although most traders are aware of the association, it bears reminding: profit potential and loss risk are two sides of the same attribute.
To understand the risk, make sure you know how the product works. A leveraged ETF is designed to accelerate outcomes. In a 2x leveraged ETF, an investment's value will move at twice the rate of change in the index being tracked. So if the underlying index moves upward by 3%, you would expect the 2x to move up by 6%.
With a 3x leveraged ETF, the rate is even greater. If the underlying index goes up 3%, the value of 3x stock should rise by 9%, or three times the rate of growth in the underlying.
Of course, the key here is that losses are going to accumulate at the same rate, two times or three times the losses in the index of securities. In an inverse ETF, the same risk is present and it's a matter of whether you choose wisely. If the index moves up when you expect it to move down, you lose. However, as a matter of risk, the inverse leveraged ETF is very advantageous. The alternative -- shorting the ETF -- is extremely risky on two levels. First is the well-known market risk of loss if the index moves in the wrong direction. Second is leverage itself. You are going to lose at twice the rate of index loss (in a 2x) or three times that rate (in a 3x). By the way, margin maintenance requirements for shorting leveraged ETFs can be as high as 90%, so you cannot "leverage the leverage." (In a margin account, you achieve leverage by borrowing a portion of the amount invested. When you also have leverage in the product, you augment the whole thing; so as a result, margin levels are much higher due to the added risk.)
It comes down to a question of risk. Leverage equals acceleration. And remember, this means both sides -- profit or loss -- are going to grow at much faster rates than the traditional non-leveraged ETF or older-style mutual fund. Yes, you can make more money, faster. But you can also lose more money, also faster.
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