The benefits of trading leveraged ETFs.

I only trade the S&P 500’s leveraged ETFs in my medium-long term portfolio. Leveraged ETFs are an ideal financial product for traders to profit from their market outlook. Here’s why.

Leveraged ETFs have compounding.

Leveraged ETFs compound on themselves during a bull market. The more steady the rally, the more the leveraged ETFs compound on themselves.
This is exactly the opposite of ETF erosion.
Leveraged ETFs match the underlying market’s day-to-day returns. This means that a leveraged ETF will perform better than you think when its underlying market is going up.
Let’s assume that the market goes up 100% a year.

  1. The underlying market will go from 1, to 2, to 3, to 4, to 5.
  2. A 3x leveraged ETF will go up 300% a year. It will go from 1, to 4, to 16, to 64, to 256.

As you can see, the 3x leveraged ETF outperforms the underlying market by far more than 3x (256/5 = 50.1x outperformance). This is because the leveraged ETF compounds on itself.
Hence, leveraged ETFs magnify your returns exponentially when the trend is strong and on your side.
Of course it’s also important to sidestep big bear markets. Bear markets destroy leveraged ETFs due to erosion (see post).
Sidestepping “significant corrections” is not mandatory, but it’s nice to have. Significant corrections generally don’t cause a lot of ETF erosion. Erosion is only a massive problem during bear markets.

Leveraged ETFs allow you to beat most professional traders.

Here’s a simple strategy that most people don’t realize. Most traders are happy to achieve 10% a year. You know what simple strategy achieves 17% a year? Buying and holding a leveraged ETF for the U.S. stock market.

  1. The S&P 500 has yielded an average annual return of 7.8% from 1950-present.
  2. A 3x leveraged ETF – even after including bear market erosion – will average an annual rate of return of 16.4% from 1950-present!

A leveraged ETF will never lose all its value the way a futures contract or options will. This means that if all you did was buy and hold a leveraged ETF, you will significantly beat a buy and hold strategy.
Here’s what a hypothetical UPRO (3x S&P 500 ETF) will look like from 1950 to present.

Notice how erosion during bear markets has taken a significant bite out of UPRO’s value. That’s why you should know how to predict and avoid bear markets. But even then, UPRO still significantly beats buy and hold and the returns of most traders.

You can take advantage of erosion  when shorting a leveraged ETF.

Leveraged ETFs will face erosion (lose value) when the market swings sideways for a long time or when the market is in a bear market. This means that by shorting a leveraged ETF, you can make money just from the erosion alone.
Let’s assume that you’re bearish on the market. You short a leveraged ETF. The market doesn’t need to actually fall. The market swinging sideways is enough for the leveraged ETF to lose value to erosion. You will profit from that erosion.

Leveraged ETFs are better than futures and options.

Many traders use the leverage in futures and options to magnify their returns. This is not safe.
Futures and options do not allow traders to hold their positions until they are right. The market might move against your position in the short term. You can hold your leveraged ETF until the market reverses in your favor. You can’t do that with futures and options.

  1. Futures traders always face the prospect of margin calls if they don’t set aside enough cash. And it’s not possible to always calculate the precise amount of margin (cash) that you need to set aside. You really can’t predict how much the market will move against your position in the short term. You can’t always calculate the worst-case scenario correctly. All it takes is one big margin call to wipe out your account.
  2. Options have an expiry date. If the trade doesn’t work out before that expiry date, you will lose everything you paid for the options. You can’t hold your position until the market reverses in your favor.

11 comments add yours

  1. Examples of inverse leveraged ETF obliteration can be appreciated by those holding ETF’s such as SDS and DXD which have reverse split over the past 5 years. During a bear market, if the price of SSO falls enough (typically closer to single digits but not always), it may undergo a reverse split. If that happens, it could be a decade or more before break even may be appreciated. That would be a very slow, painful process. Just something to consider when purchasing leveraged ETF’s on either side.

    • I should have been more clear: do not trade inverse ETFs unless you do so with really small position sizes.

      • Thank you for the warning Troy, good to know – I like your blog probably more for it’s “dont’s” than for its “do’s” 🙂 But the inverse ETFs are still terra incognita for me, so could you please write a review on those one day? Especially, what are the biggest risks of investing in them during bear market – are they subject to any “internal” margin calls? Some numerical comparison would be welcome – say, performance of ETF ABC while markets grow 100%, vs. performance of ETF Inverse ABC while markets fall by 50%.
        Why I am so interested: I am long HEU (2xTSX energy index), it has oscillated dearly for the months that I have it, but made very minor drawdowns when the index would return to the initial point… but its inverse “twin” draws down much worse when the market returns to the same point – meaning that the direct and inverse funds behave asymmetrically, and I don’t understand why. Could that be due to higher costs related to holding short positions within the fund? Or internal margin calls? Your opinion would be much appreciated!

          • Thanks Troy, but as you recommend against bear ETFs ever (and I’m leaned towards following your advise, possibly as most of your readers), this study becomes purely academic, you can put it onto the back burner.

  2. Troy, holding a short position also exposes you to the margin call risk if things go wrong. Nowadays, all index (leveraged and not) “bull” ETFs have their inverse “brothers” – “bear” ETFs with mirror reflection of daily returns of bull ETFs (I call them anti-ETFs). If you are long on them, they obviously are not subject to margin calls, but what other risks do they ensue (on top of erosion in bull markets of course)? Have you compared the strategy “short ETF” vs. “long anti-ETF”? It would be interesting to compare the results: in a foreseeable future we’ll need either of those!

    • I would never short an ETF, whether it be inverse or not. That raises the same margin call problems.

      • Neither would I, but inverse ETFs look attractive for future bear market. Have you used them during bears or significant corrections?

        • No, and I don’t plan on it. Bear markets are much harder to trade than bull markets. If your timing is wrong, then you might short too early. It’s much easier to make money in a bull market than in a bear market. That’s why the easiest strategy is to do nothing in a bear market and buy and hold during a bull market. That alone beats 95% of traders.

  3. Can you present that impressive graph (hypothetical 3xS&P since 1950) on a log scale? It would look more informative, as the main concern is how significant corrections (such as 2011 or 2015-16) erode the fund, and how much it is behind when the market recovers.
    BTW, oscillating markets (like nowadays) are detrimental for leveraged ETFs too. Example:
    Imagine a market that drops by x (percentage points) on day 1 and fully recovers on day 2 (for that, his performance on day 2 must be x/(1-x).) Take a 2x leveraged ETF. Its value after day 2 will be (initial value=1):
    (1-2x)[1+2x/(1-x)]. Omitting simple algebra, the result is: 1-2x^2/(1-x). The negative component is the erosion in the 2-day cycle when the underlying index fully recovers.
    If that roller coaster repeats for n cycles (2n trading days), the erosion makes: [1-2x^2/(1-x)]^n.
    When daily changes are small and n is not huge – not a big deal. For x=1%, n=50 (100 trading days), the defect after 50 cycles is only 1.1%. But for x=3%, n=50, the defect is already 9%. And if it is a 3xETF – the erosion is
    [1-6x^2/(1-x)]^n. In the 2 previous numerical examples, the erosion would be
    3% for x=1%, and 24% for x=3%! Bad thing to hold long-term in uncertain market.
    Same results if the market doesn’t oscillate but rather makes a big drop and V-recovery: that will only affect the sequence of factors in the composition, not affecting the result.

    • Will do Oskar in a future study.
      Also, that’s why UPRO erosion isn’t anywhere near as bad as NUGT’s erosion. Like you said, the bigger the daily changes, the more of a problem erosion becomes.

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