Understanding Leveraged ETF Risk and How to Mitigate It

Leveraged ETFs are designed to provide a multiple of the daily return of a specific index, but they come with unique risks.

These funds use derivatives to amplify their returns, which can result in significant losses if the market moves against them.

Leveraged ETFs typically reset their daily returns at the end of each trading day, which can lead to compounding effects that increase the risk of losses.

To mitigate this risk, investors can consider using stop-loss orders to limit their losses if the market moves against them.

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A leveraged ETF, or LETF, is a security that uses financial derivatives and debt to amplify the returns of an underlying index or other assets it tracks.

Most LETFs aim to track daily changes, resetting each day, but some may use longer reset periods, such as one month. They can come from borrowing or the use of derivatives like futures contracts, forward contracts, total return swaps, and options.

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These derivatives allow LETFs to employ "synthetic replication", a method that's generally more efficient than borrowing to buy the securities of the benchmark. Options, for instance, have upfront fees called premiums that can add to gains for LETFs over traditional ETFs.

Here are some key types of derivatives used in LETFs:

ETPs, or Exchange-Traded Products, are a type of investment vehicle. They're designed to track an underlying index, commodity, or asset, and can be traded on an exchange like stocks.

Direxion Daily Leveraged and Inverse ETFs are a type of ETP. These funds are designed to seek daily leveraged investment results.

Bull funds aim to achieve 300% or 200% of the performance of their benchmark index before fees and expenses. Bear funds, on the other hand, aim to achieve 300%, 200%, or 100% of the inverse of the performance of their benchmark index.

There is no guarantee that these funds will achieve their investment objective.

An ETF, or exchange traded fund, is a type of investment that tracks the performance of a specific index, such as the Nasdaq 100 Index or the Dow Jones Industrial Average.

ETFs are traded on stock exchanges like individual stocks, making them a popular choice for investors.

A traditional ETF typically tracks the securities in its underlying index on a one-to-one basis, meaning if the index goes up 10%, the ETF will also go up 10%.

Some ETFs track single stocks or crypto market or futures prices, which can make trading more complex.

These funds are designed to provide investors with a way to gain exposure to a particular market or sector without having to buy individual stocks.

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Decay risk is a significant concern when investing in leveraged ETFs, as they are designed to be traded in short-term windows. The longer you hold the fund, the decay risk starts to creep in.

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Frequent monitoring of your position is recommended, as situations can evolve rapidly, especially in volatile markets. This is crucial to act accordingly and minimize losses.

Leveraged ETFs can be complicated, and it's essential to understand how they achieve their stated objectives and the risks involved. Ask about the techniques used to achieve their goals and the risks they involve.

Some leveraged ETFs may not meet their stated daily objective, which can impact the performance of your portfolio. Be sure you understand the impact this could have on your investment, considering your goals and risk tolerance.

The fees and expenses associated with leveraged ETFs can be higher than traditional ETFs, so it's essential to use a tool like FINRA's Fund Analyzer to estimate the impact on your investment.

Here are some key risks to consider when investing in leveraged ETFs:

In trending markets with low volatility, leveraged ETFs can perform better than the benchmark index, but this can quickly turn into a disadvantage in volatile markets. This is because the fund must respond to gains by increasing its exposure to the benchmark index, and respond to losses by decreasing its exposure.

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Decay risk is a significant concern for leveraged ETFs. This is because the daily rebalancing can lead to a continuous pattern of losses or gains, resulting in a decay of the longer-term returns of the fund. In fact, a continued pattern of increased exposure in advance of a loss can generate a larger loss, and decreased exposure in advance of a gain can decrease the impact and benefit of future gains.

Volatility can be particularly damaging to leveraged ETFs. In flat markets with high volatility, the daily rebalancing can cause the fund to lose more than the benchmark index. For example, a 2x leveraged ETP may lose 4% over a couple of days, while the index loses only 1%.

The longer you hold a leveraged ETF, the more decay risk you'll face. This is why it's essential to have clear targets for entry and exit points before investing in a leveraged ETF. Consider the reduced time horizon when developing a strategy and pricing targets for a potential short-term move.

Here are some key facts to keep in mind:

It's crucial to understand the risks associated with leveraged ETFs before investing. By being aware of these risks, you can make informed decisions and avoid potential losses.

Counterparty risk is the risk of monetary loss a firm may be exposed to if the counterparty encounters difficulty meeting its contractual obligations under the terms of the transaction.

Direxion strives to minimize counterparty risk by diversifying its portfolio of relationships for swap and futures contracts across multiple brokers.

Swap contracts allow two counterparties to exchange one stream of cash flows for another, calculated over a notional principal amount that's usually not exchanged between counterparties.

This can create unfunded exposures to an underlying asset, as counterparties can earn the profit or loss from movements in price without having to post the notional amount in cash or collateral.

Direxion regularly monitors the balance sheets of all counterparties and will suspend or terminate relationships with any organization that shows material signs of insolvency.

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Sophisticated investors understand that Direxion Daily Leveraged ETFs are designed for those who can handle substantial losses in short periods of time.

To be suitable for these funds, investors must be willing to accept the unique risks and performance characteristics of leveraged daily investment results.

They also need to have time to manage positions frequently to respond to changing market conditions and fund performance.

Conservative investors, on the other hand, cannot tolerate substantial or even complete losses in short periods of time.

They are also unfamiliar with the unique nature and performance characteristics of funds that seek leveraged or inverse daily investment results.

This makes them a poor fit for Direxion Daily Leveraged ETFs.

Here's a summary of the key differences:

Direxion Daily Funds are not suitable for buy and hold due to their daily investment objectives. They seek to magnify, or provide inverse exposure to, the returns of their benchmarks for a single day.

In trending markets with low volatility, the performance for periods longer than a day may exceed the return of the benchmark index, multiplied by the stated exposure level of the portfolio. However, in volatile markets that exhibit no clear trend or direction, the impact of daily rebalancing can be harmful to the performance of leveraged ETFs over time.

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Daily rebalancing causes a leveraged ETF to respond to gains by increasing exposure to the benchmark index, and respond to losses by decreasing exposure each day. This can result in a larger loss when the market declines, and a decreased benefit from future gains.

The longer you hold a Direxion Daily Leveraged ETF beyond a couple of days or weeks, the decay risk starts to creep in. This is because the fund's exposure is a product of its target magnification and its net assets, which can lead to a reduction in exposure in an amount which is a multiple of the decline in the net assets.

To manage decay risk, it's essential to have clear targets for entry and exit points before investing in a leveraged ETF. Consider the reduced time horizon when developing a strategy and pricing targets for a potential short-term move.

Sophisticated investors who are willing to accept substantial losses in short periods of time are a good fit for Direxion Daily Leveraged ETFs. These investors understand the unique nature and performance characteristics of these funds, which seek leveraged daily investment results.

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On the other hand, conservative investors who cannot tolerate substantial or even complete losses in short periods of time should exercise caution. They are unfamiliar with the unique nature and performance characteristics of funds that seek leveraged or inverse daily investment results.

To assess your risk tolerance, consider the following factors:

If you've answered "yes" to the first question and "no" to the second and third, you may be a good fit for Direxion Daily Leveraged ETFs. However, if you're unsure or have any doubts, it's best to seek the advice of an investment professional before making an investment.

Leveraged ETFs use derivatives like futures contracts, forward contracts, total return swaps, and options to amplify exposure to an index or asset. This is known as synthetic replication, which is generally more efficient than borrowing to buy the securities of the benchmark.

The leverage in LETFs comes from borrowing and derivatives. For instance, a fund might take your invested funds and then borrow the same amount to effectively double how much is invested. LETFs also employ derivatives like forward contracts and total return swaps.

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A leveraged inverse ETF attempts to use its leverage to make money when the underlying index is declining in value. In other words, an inverse ETF rises while the underlying index is falling, allowing investors to profit from a bearish market or market declines.

Here are some key derivatives used in LETFs:

Leveraged ETFs use derivatives to magnify exposure to a particular index or asset, allowing investors to potentially gain more than the underlying market. This is achieved through various sources, including borrowing and the use of derivatives like futures contracts, forward contracts, total return swaps, and options.

Futures contracts, for instance, are agreements to buy or sell an asset at a predetermined price at a specific time, while forward contracts are customizable private agreements to trade an asset at a set price in the future. Total return swaps involve one party paying the total return of a tracked asset to another party, which pays a fixed or floating rate.

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Options contracts grant the ability to buy (a call option) or sell (a put option) an underlying asset without the obligation to do so. Options have upfront fees called premiums, which can add to the gains for LETFs over traditional ETFs.

A leveraged inverse ETF attempts to profit from a bearish market or market declines by using its leverage to make money when the underlying index is falling in value.

Here's a breakdown of the leverage in LETFs:

The daily reset mechanism causes LETFs to rebalance their portfolios daily to maintain their leverage, which can cause longer-term returns to diverge significantly from simply compounding the underlying index's returns. This can result in a decay of the longer-term returns of the fund, especially in volatile markets with no clear trend or direction.

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Some leveraged and inverse ETPs have been able to prolong their existence by using a reverse share split, which exchanges multiple lower priced shares for a new, single share with a higher price.

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This technique raises the share price, but reduces the number of shares an investor owns, leaving the total value of the investment unchanged.

Not all leveraged and inverse ETPs that have been shuttered have undergone a reverse split prior to closing, but it's a strategy used by issuers to avoid delisting poorly performing funds.

Investors will see a higher share price in their accounts after a reverse share split, but the number of shares they own will decline.

Leveraged ETFs can be complicated and involve significant risks, including the risk that they may not meet their stated daily objective. This means that even if the underlying index performs well, the leveraged ETF may not keep pace.

In volatile markets, the impact of daily rebalancing can be particularly damaging, causing the fund to lose more money than the benchmark index. For example, if the market is flat but volatile, the fund's exposure to the index may increase in advance of a loss, leading to a larger loss.

If you hold a geared ETP longer than one trading day, you could suffer losses even if the underlying index is up. This is because the fund's exposure to the index will increase in advance of a gain, but decrease in advance of a loss, leading to a decay of the longer-term returns.

Here are some key things to consider when evaluating the risks of leveraged ETFs:

If an ETP closes, investors may have to wait for the final distribution of cash, which can take around a week after delisting.

Investors who find themselves holding an ETP that has announced its closure can sell their shares before the delisting date instead of waiting for the final distribution.

The process for closing an ETF is fairly straightforward, but ETNs can be more complicated, with the closure process depending on what was written into the note's prospectus.

Some ETNs have no provisions in their prospectuses to allow for accelerated redemption, leaving investors with limited options.

Investors who need to find information about an ETF or ETN that has announced its closure can start by checking the issuer's website, where they should be able to find key dates and details about the closing process.

Trading an ETN on the national exchange before delisting is generally a better experience than trading over the counter, so it's worth acting quickly if your note is being delisted without accelerated redemption.

Some leveraged and inverse ETPs have used reverse share splits to prolong their existence, exchanging multiple lower-priced shares for a new, single share with a higher price.

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Leveraged ETFs are designed to deliver multiples of the daily performance of a specific index or asset, using derivatives as leverage to amplify both gains and losses.

Their complex nature and daily rebalancing make them unsuitable for longer-term investments, as seen in the example of the 2x ETP that lost 4 percent over two days while the index lost just 1 percent.

Investors should use caution when dealing with LETFs, as they entail higher risk and volatility than traditional ETFs, with sensitivity to market fluctuations and costs associated with their operation.

The U.S. Securities and Exchange Commission warns investors to understand the mechanisms and potential impacts of LETFs on their investment portfolios, as highlighted in the Investor Bulletin: Leveraged and Inverse ETFs.

A key consideration is the daily rebalancing of LETFs, which can result in significant losses, as demonstrated in the example of the 2x ETP that lost 20 percent of its value in one day.

Here are some key characteristics of LETFs to keep in mind:

Overall, LETFs are best suited for experienced traders who can handle the complexities and risks involved.