Learn how you can triple your returns with advanced ETF strategies (Leveraged ETFs & Inverse ETFs).
Even if you’re new to trading and the stock market, you’ve probably already heard of exchange traded funds or ETFs. You might even employ a few of them, right now, in your portfolio to help round out your investment strategy.
But unless you’re a power trader or someone that is seasoned and experienced in the equities market — you likely wouldn’t have had much exposure to some of the more advanced forms of ETFs call Leveraged & Inverse ETFs.
These specialized financial instruments are what professionals and veteran retail traders often utilize, to execute some precision trading techniques within their overall investment plans.
In this article, I’m going to shed some light on these topics so that you get a comprehensive view of what these advanced financial instruments are, what the benefits and risks are, and how you might integrate them into your own portfolios so that they fit into your overall trading plan.
A while back, I wrote this beginner’s guide to mutual funds and ETFs — where I explained the origin concept of these 2 investment vehicles and highlighted some of the foundational things you need to know, in order to start investing with them.
So before we continue on, in this article, if you haven’t already read that story, make sure you check that out first. It’ll give you a good foundation on what ETFs are and the concept behind their creation — which is important to know before we dive deep into these specialized forms of ETFs.
But as a quick refresher course, let’s take just a few moments and set the baseline definition of ETFs first.
1) What are ETFs?
ETFs or Exchange Traded Funds are investment vehicles that are made up of a collection of different securities, like stocks or bonds, etc — that you can trade in the open stock market. As a retail trader, it’s sometimes hard to pick the right company or stock to invest in. Sometimes, you just want to invest in a particular strategy or category of the market.
For example, let’s say you really had a passion for Pets and you wanted to invest in an area of the stock market that benefited your furry companions. Well, you could invest in the ETF PAWZ, which contain holdings of pet related companies like Chewy Inc, Fresh Pets, and Petmeds Express.
Or, if you’ve always dreamed of flying through space, like the guardians of the galaxy, then you’d probably want to throw your money into an ETF like UFO — which is comprised of aerospace and space flight & communications companies like Virgin Galactic Holdings and Maxar Technologies.
But more commonly, most people are interested in investing in the stock market as a whole or a particular sector of the market — and that’s where index funds come into play. Index funds make up the majority of the ETFs in the market and they track against broad market indexes like the Dow Jones Industrial Average or the S&P 500.
All in all, whatever your trading philosophy is, ETFs provide an optimized way to invest in that particular area of the market, without all of the hassles and risks of selecting individual stocks.
2) Leveraged ETFs
So, now that we’ve refreshed on the basics, let’s dive into the first of the specialized types of these financial instruments — called Leveraged ETFs.
As we just previously discussed, you already know that most ETFs track an underlying market index. So for example, if you invested in an ETF like DIA, the SPDR Dow Jones Industrial Average ETF, then on any given day, if the Dow rises 1%, then this DIA ETF, would also gain 1% — as the fund aims to mirror the performance of this DOW Jones market index.
But there are also different versions of these ETFs that are leveraged and designed to return multiples of an index’s performance. For example, if you invested in an ETF called the ProShares UltraPro Dow30, ticker symbol UDOW — whenever the Dow rose 1% in any given trading day, UDOW would rise 3% and give you a 3x return vs the index. This is what we call a triple-leveraged ETF, because it’s designed to provide a 3x multiple on the index performance. Sounds awesome, right?
These leveraged ETFs are typically used by day-traders as they look to achieve maximum intraday gains from their trades. Because of this multiplication factor, given the right market conditions, you would potentially see swings of 6%, 10%, 15% or even in some cases, upwards of 20% performance in any one given day.
Let’s take a look at this table.
This is something that CNBC published a little while back that showed the daily swings of the S&P 500 during the early stages of the COVID pandemic. If you look at Friday, March 13th — on that day, we saw the single largest daily gain in the S&P 500 since October of 2008. That day, the S&P 500 gained 9.3%. If you were holding an S&P 500 index fund on that day — you’d be pretty pleased. BUT if you had been holding this triple leveraged ETF — the Direxion Daily S&P 500 Bull 3X Shares ETF, ticker symbol (SPXL) — then on March 13th, you would have seen a gain of 26.9%! If you had $10,000 invested in that ETF, your return on that single day would have been $2,690!
Now that’s really impressive — but it’s important to note that this leverage works the other way as well. On that following Monday, March 16th, the S&P 500 dropped 12% — making it the single biggest decline day since 1987. If you were holding SPXL on that day, you would have lost 33.9% of the value in your fund. That means that same $10,000, would have been reduced to $6,612.
It’s important to remember this, that the leverage factor happens both ways — equal risk to equal reward.
Also, as you dive deeper into the research on leveraged ETFs, you’ll find that the leverage factor in different ETFs comes in various degrees, as well, ranging from 1.5x to 3x in return — so if you’re interested in buying into a leveraged ETF, you can also decide how much of a multiple you’d be willing to risk in your investment.
But you as you can clearly see — because of the multiplication effect of these leveraged ETFs, if you happen to be lucky enough to make an entry when the market is going up — these specialized financial instruments could end up netting you a sizable gain in a very short period of time. That’s why these leveraged ETFs are popular choices among day traders and short term swing traders.
Now reading this, you might be wondering, “Why is it only popular with short term traders? Why wouldn’t someone just buy and hold these leveraged investment vehicles for the long term? The previous bull run, that we just had, lasted about 11 years, from 2009–2020. And in that time, the stock market rose over 357% — so if we’ve held a triple leveraged ETF all this time, wouldn’t that have been a gain of 1070%?
It’s a great question — but there is a specific answer as to why most traders don’t hold on to leveraged ETFs for the long term. And it has to do with something called the Decay Factor.
You see, the reason why long term holding of leveraged ETFs is dangerous — is that leveraged ETFs are rebalanced every day to maintain that multiple ratio with the index. So when the market has a down day, the losses in the leveraged ETF are fully captured and realized… which means if you have further down days, the effect is compounded and the loss in the fund is proportionally greater than compared to the index that it is tracking against. Here is a simple example that explains what I mean.
Suppose you buy 1 share of a 3x ETF at $100.00.
Day 1: Market goes up 10%: Tracking Index = $110.00 (+10%), 3x ETF = $130.00 (+30%)
Day 2: Market goes down 10%: Tracking index = $99.00 (-10%), 3x ETF = $91.00 (-30%)
Day 3: Market goes up 10%: Tracking index = $108.90 (+10%), 3x ETF = $118.30 (+30%)
Day 4: Market goes down 10%: Tracking index = $98.01 (-10%), 3x ETF = $82.81 (-30%)
Now if you look at all 4 days, in aggregate — given that the price action was simply up and down by the same percentage points on each day, you would think that you should be back to even with your investment amount, right?And with the tracking index, you are close — but see what happens to the 3x ETF?
That $82.81 — shows the result of the “decay factor” that eats away at your capital due to the leveraged nature of the fund. In order to hold long term and make a decent profit from leveraged ETFs, you have to have significantly more up days (early on) than down days — otherwise this “multiple decay” factor will kill you. And this is all without the consideration of the really high management fees that 3x ETFs typically have, as well.
So considering all of this, leveraged ETFs may be instrumental in short term play, but holding them too long exposes you to a higher possibility of value degradation due to the decay factor — which makes these financial instruments dangerous to hold for too long.
However, just like how the leverage factor works in both market gains and losses, the decay factor also works on the positive end, as well. This means that if you were lucky enough to buy into the leveraged ETF in a period where the market rose, and you saw many successive days of positive gains in this ETF early on, you could potentially make even more than the projected multiple for the fund. In that case, you could, hold on to the fund as long as you felt comfortable — but that’s a decision you’ll have to make for yourself based on your respective situation.
3) Inverse ETFs
Now let’s talk about Inverse ETFs. This type of ETF, is a bit more straight forward. Basically, these ETFs aim to achieve the opposite performance of their underlying index. So for example, if the Dow Jones Industrial Average dropped 3% in any given day, an ETF like the ProShares Short Dow30, ticker symbol DOG, would be positive 3% for the session. It basically aims to perform in the inverse of whatever it’s underlying index is.
But what’s really interesting, is that there are categories of ETFs that combine both the leveraged and inverse characteristics of ETFs. These Leveraged Inverse ETFs provide both an opposite AND a multiplied performance to their underlying index.
Here is a quick list of some of the more common ETFs in this classification, that are sponsored by a financial firm called Proshares.
ProShares is a financial firm that specialized in the creation/management of these types of ETFs and if you look at the MarketCap section — these are the listed advanced ETFs that track the 6 common broad/total market indexes. And this is just the tip of the iceberg — there are hundreds of similar ETFs out there, from a variety of different sponsors/firms, all with their own unique flavors and styles to them.
So, now that you are aware of these advanced types of ETFs, you might ask yourself, “What is the best way to utilize them?”
3 Ways to Utilize Specialized ETFs
Well, there are three main scenarios in which you’d want to use these specialized ETFs.
1) First, whenever you are holding a long equity position, but feel like the market is turning in the opposite direction, as a safety hedge, you could take a small position in a leveraged inverse ETF. If you were using a triple leveraged inverse ETF, in order to hedge your initial investment, theoretically, you’d only need to invest another third of the original principle of your long position, to break even. That is, assuming that you were correct on the market direction, of course.
2) Secondly, if you were planning to Short a particular equity, you could use an inverse ETF as a safer alternative. Buying into an inverse ETF eliminates some of the inherent risks of holding a short position, like capping the potential loss you can incur to only what your principle investment is, as well as ensuring more execution reliability — as you don’t have to depend on your broker to find a share of that particular equity to borrow, for your short sale.
3) And lastly, leveraged ETFs are a great way to take advantage of some momentum trading, especially when the entire market rallies from positive news. Let me give you a quick example. On April 29th of this year, the market had a strong rally off of the positive earnings reports from Microsoft, Facebook and a few other notable companies. And if you look at the ProShares UltraPro QQQ, ETF (TQQQ)for that day, this ETF, which is a triple leveraged ETF that tracks the NASDAQ 100 — started rising at 9:41am EST, and by 10 mins till closing, it reached a gain of over 6%.
Now it did sell off a little bit into the close as you can see there towards the end of the chart — but if you rode this wave from the start of the morning, you would’ve clear a solid 5%-6% off of the momentum in the market. These are the times where day and swing traders utilize these specialized ETFs to actualize quick profits.
Hope this provides you guys some clarity on Leveraged and Inverse ETFs and gives you some more confidence when choosing to utilize them in your portfolio.
In conclusion, I’ll just leave you guys with this one thought.
While these specialized types of ETFs are a bit more complicated to understand than other types of equities, I’d encourage you guys to really spend some time to research and learn as much about them as you can — because once you’re comfortable trading with these kinds of tools, your ability to be nimble and creative with your investment tactics and strategies, will grow immensely.
**** Disclaimer *****
The content here is strictly the opinion of Daniel’s Brew and is for entertainment purposes only. It should not be considered professional financial investment or career advice. Investing and career decisions are personal choices that each individual must make for themselves in accordance with their situation and long term plans. Daniel’s Brew will not be held liable for any outcome as a result of anyone following the opinions provided in this content.