Leverage ETF's: What are they and how do they work?

What is a leveraged ETF?

To understand what a leveraged ETF is, we first have to recap what a regular ETF is. Remember, you can think of an ETF as a basket of stocks grouped together that you can buy and hold all at once. A leveraged ETF is exactly like that basket, but on a skateboard going up and down slopes super fast! Instead of matching the regular ETF, it uses borrowed money to multiply the daily return by 2x or 3x.

• If the S&P 500 goes up 1%, a 3x leveraged ETF would go up 3%.

• If the S&P 500 goes down 1%, a 3x leveraged ETF would go down 3%.

How They Work

Imagine you have have $100 and you want to invest in the S&P 500. A normal ETF would just invest that $100. A leveraged ETF plays it a little differently. They say, "Hey, I'll take your $100, borrow another $200, and invest a total of $300 into the S&P 500." This is exactly how leveraged ETFs can multiply a regular ETFs performance. Say the S&P 500 goes up 1% in a day. Your $300 investment would grow by $3, but since you only put in $100, thats a rather 3% gain for you!

People that run these ETFs don't just walk into banks and ask to borrow money. They use these little special agreements called derivatives!

• Futures: Agreements to buy or sell something in the future at a set price

• Swaps: Trades where they agree to exchange returns with another investor

• Options: Contracts that give them the right to buy or sell later

Futures, Swaps, and Options will be explained in much further detail in a later lesson, but for now just understand that leveraged ETFs are made possible with borrowed money.

What's the risk

Just how you can gain 2x-3x your money, you can also lose that much. A daily ETF is even riskier when you consider the fact that daily ups and downs eat away at its value even if the index were to end up flat over a month. Because of this, most leveraged ETFs are designed for short term holdings, not something that would go into savings.

Who, When, and Why do people use them?

First we have regular traders. These people want to make big bets on short term moves in the market. So, when the market is super volatile, (take Trump's tariffs for example) traders try to capitilize. Next we have Hedgers. To hedge the market is to protect your portfolio against a market drop. For example, some investors use inverse ETF's to protect the amount of money they lose during a market selloff. Finally, the last reason people use leveraged ETFs is becuase of market speculation. Some people think they know exactly where the market is moving so they try to capitalize on that thought. Most of the time this doesn't work out because nobody really knows where the market is going.

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