How to invest in a leveraged ETF – explanation
With a leveraged ETF, you can quickly achieve a significant return. However, unlike a normal ETF, leveraged ETFs are everything but stable and relatively safe. In this article, we will discuss how leveraged ETFs work.
What are ETFs?
Before we dive into what a leveraged ETF is, let’s briefly discuss what normal ETFs are. An ETF is an exchange-traded fund, which means that you can trade the fund on the stock exchange.
A normal ETF tracks a certain index, such as the S&P500 or AEX, but it can also be a basket of cannabis stocks. You can then invest in these at relatively low costs.
If you want to read more about what ETFs are and how they work, read this article:
What is a leveraged ETF?
A leveraged ETF is an ETF that allows you to invest with a leverage in the underlying securities.
When you invest in the AEX with a normal ETF, and it rises by 3%, the ETF would also increase by about 3%.
However, with a leveraged ETF, a leverage is applied, which could be 3, for example. In this case, you would make a profit of 9%. The opposite can also happen, and you would lose 9% instead of 3%.
What is an inverse ETF?
With an inverse ETF, you can speculate on a price drop of an underlying index. This is also a risky investment, but can be a suitable alternative to a normal short position.
When you take a short position, your loss is theoretically unlimited. With an inverse ETF, you can never lose more than the amount you pay when you buy the investment product.
Inverse ETFs can also be leveraged, allowing you to place a leveraged bet on a declining price.
How and where can you invest in Leveraged ETFs?
Investing in leveraged ETFs works the same as investing in normal ETFs. You need an account with an online broker. I, personally, use eTorofor trading ETFs because of their low costs and high level of reliability, which makes them suitable for ETF investments. Use the button below to open an account directly with eToro:
How do leveraged ETFs work in practice?
In the table below, you can see how the return of a normal ETF develops compared to a leveraged ETF. In this example, the index starts at a price of $100.
|Price development||Normal ETF||Leveraged ETF (X3)|
As you can see, leverage can greatly affect the return. On the first day, in this example, you would achieve a much higher return with the leveraged ETF. However, losses also pile up much faster, resulting in a much lower return.
This is because the results are calculated every day. If you enter at the wrong time, you can lose a lot of money with leveraged ETFs!
Investing in leveraged ETFs is therefore only suitable for active traders and not for people who want to invest in the long term. Leveraged ETFs work completely differently from normal ETFs, which are excellent for long-term investments.
Therefore, only invest in leveraged ETFs if you understand these risks well and are willing to lose a large portion of your investment.
How is the price of a leveraged ETF determined?
A leveraged ETF uses derivatives to achieve leverage. For example, the funds work with option contracts that amplify the daily returns on the fund. It is advisable to investigate which derivatives a leveraged ETF uses to achieve leverage. Only invest in the leveraged product when you fully understand how it works.
Leveraged ETFs are always synthetic by definition: this means that the underlying securities of the ETF are not held.
How much does investing in leveraged ETFs cost?
In theory, if you enter at the right time, you can achieve a high return with leveraged ETFs. However, the costs of a leveraged ETF are much higher, which means you have to achieve much better results to achieve a good result.
This is the case because high premiums must be paid for the derivatives. In addition, money is borrowed to apply the leverage: you then invest on margin. As a result, the cost percentage of a leveraged ETF is often above 1%, while the costs of normal ETFs are often 0.5% or less.
When investing in an inverse leveraged ETF, costs can increase even further: sometimes up to 3%. Therefore, do thorough research into the cost structure before executing an investment in leveraged ETFs.
Who are leveraged ETFs suitable for?
Leveraged ETFs are especially suitable for active traders who want to speculate on price movements in the index. Due to the high-cost structure and high risk, leveraged ETFs are not suitable for long-term investments.
Leveraged ETFs are in any case not suitable for novice investors: the ETF’s are not very transparent, and the return you achieve can vary greatly from the return that the actual index achieves.
What are the risks of leveraged ETFs?
Leveraged ETFs carry a high risk and are therefore not suitable for passive investors. Due to the leverage, you can lose significant amounts quickly. Consider whether you are willing to take this high risk before investing in a leveraged ETF.
What are the advantages of leveraged ETFs?
- You can potentially achieve high returns with leveraged ETFs
- You can use a leveraged ETF to bet on a declining price
- Leveraged ETFs are cheaper than many other leverage products
- Leveraged ETFs are suitable for short-term investments
What are the disadvantages of leveraged ETFs?
- Leveraged ETFs have a high risk of loss
- Leveraged ETFs are expensive: costs can add up significantly
- The returns can deviate significantly from those of the normal index
- Leveraged ETFs are not suitable for long-term investments
When I was 16, I secretly bought my first stock. Since that ‘proud moment’ I have been managing trading.info for over 10 years. It is my goal to educate people about financial freedom. After my studies business administration and psychology, I decided to put all my time in developing this website. Since I love to travel, I work from all over the world. Click here to read more about trading.info! Don’t hesitate to leave a comment under this article.