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Leveraged ETFs to take advantage of volatility
Leveraged ETFs offer sophisticated short-term investors a convenient – albeit high risk - way to amplify returns in today’s volatile market.
2022 will no doubt be remembered as one of the most volatile years on record for global stock markets. This volatility is driven by a high degree of uncertainty relating to geopolitical events, inflation, and a rising interest rate environment, all while the global economy still recovers from the impacts of the Covid-19 pandemic. While volatility is largely seen as a negative for investors, it can also present an opportunity for market-savvy traders.
For short-term traders who wish to express a high-conviction view, a low-cost way of generating returns from volatility could be through the use of leveraged ETFs which seek to amplify daily returns. However, the very nature of these products means they come with a high degree of risk which short-term investors need to be cognizant of, while long-term investors are perhaps better served staying away from leveraged ETFs altogether.
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Volatility rules today’s markets
The VIX Index (which captures the implied volatility in equity markets), also known as the “fear index” has averaged $25.92 year-to-date in 2022 (vs. $19.66 in 2021), up 32% year-over-year.
What does this mean? There is significantly more expected risk in the financial markets in 2022 than just a year ago. This principally comes down to one thing: uncertainty.
- There is uncertainty about how the Russia-Ukraine war will impact the globe (economically, politically, and militarily)
- There is uncertainty around pandemic resurgences and potential lockdowns not to mention the current lockdowns in China (the second-largest economy in the world)
- There is uncertainty around high inflation rates and how long they will continue
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With all this uncertainty, the market is acting extremely reactively – with economic data points and other news events driving large swings in the prices of assets.
As an example, the three largest daily price increases in 2022 for the S&P 500 were +5.5%, +3.1% and +3.1% (vs. +2.4%, +2.1% and +1.9% in 2021).
The three largest daily price declines in 2022 for the S&P 500 were -4.3%, -4.0% and -3.9% (vs. -2.6%, -2.4% and -2.3%).
Taking advantage of volatility using leveraged ETFs
Sophisticated investors can take advantage of volatility and large daily price swings if they are able to analyze market reactions correctly, structuring trades on the movements of individual stocks or bonds. Alternatively, when conveying a view on a broader set of securities, leveraged ETFs may be an optimal way to increase prospective returns.
What is a leveraged ETF?
A leveraged ETF utilizes either debt or derivative instruments to modify the return profile of certain securities. The most common leveraged ETFs will amplify the returns of a specified index, for example, double or triple the daily return of the S&P 500 or Nasdaq-100. These ETFs attain 2x or 3x the exposure of their underlying index by actively using index futures, options, or equity swaps. While this makes them inherently riskier, it also significantly increases potential returns.
For example, against the backdrop of this year’s high inflationary fears, if a trader expects lower-than-expected inflation, they can utilize a leveraged S&P 500 ETF to capture the positive reaction of the stock market to a greater degree. For a trader that has a high conviction of how certain macro-events will play out, and the market’s subsequent reaction, leveraged ETFs can be an extremely effective tool.
Examples of leveraged ETFs include
SPXL – Direxion Daily S&P 500 Bull 3X Shares
Provides leveraged exposure of three times (3x) the performance of the S&P 500 Index. For example, if the S&P 500 increases by +2% then SPXL will return +6%. Conversely, and most importantly, if the S&P 500 decreases by -2% then SPXL will fall by -6%.
- AUM $2.76B
- Expense Ratio: 0.97%
- 3mo Volatility: +82.6%
- 5d Flows: -$34M
- 1-year max drawdown: -63.9%
TQQQ – ProShares UltraPro QQQ ETF
Provides leveraged exposure of three times (3x) the daily performance of the Nasdaq-100 Index.
- AUM: $12.63B
- Expense Ratio: 1.0%
- 3mo Volatility: +100.51%
- 5d Flows: -$61M
- 1-year max drawdown: -90.1%
Caution ahead: there are significant risks to using leveraged ETFs
In short, leveraged ETFs are for short-term traders, and not for long-term investors. Since these ETFs seek to amplify daily returns, they are subject to erosion of long-term returns. This is much more evident when there are large short-term drawdowns or movements against the traders’ position. Just a single very large short-term drawdown can wreak havoc on a leveraged ETF’s return.
Although rare, if the Nasdaq-100 were to decrease by 20% in value in one day as an example, a 3x leveraged ETF could fall by 60% in value. This same ETF’s price would now need to increase by 150% to get back to its original value.
Bottom line: Leveraged ETFs can help traders increase their daily returns when conveying a very short-term view, meanwhile, long-term investors should exercise extreme caution with leveraged ETFs.
Data for this article is as of December 5, 2022.
Please note this article is for information purposes only and does not constitute investment advice.
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