What is a Leveraged ETF? - Decay, Risk & Volatility

Lesson Transcript
Instructor: David Bartosiak

Dave draws off his years of experience as a Financial Advisor and Analyst to teach others all about finance and the investing world.

Leveraged ETFs are short-term trading vehicles that multiply the performance of their underlying index and can move wildly in any given trading session. Learn about leveraged ETFs and a few of the common risks associated with them. Updated: 07/01/2020

The Double-Edged Sword of Leverage

Among the most controversial new products in the investment landscape are leveraged ETFs. Meant to be short-term trading vehicles, these are one of the most misunderstood products available. In this lesson, we'll explore what leveraged ETFs are along with some of the risks and opportunities made available through their use.

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  • 0:04 The Double-Edged Sword…
  • 0:24 Exchange-Traded Funds
  • 2:34 Decay, Risk, and Volatility
  • 5:31 Lesson Summary
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Exchange-Traded Funds

Traditional ETFs, or exchange-traded funds, are a basket of stocks sold as a unit which try to emulate an underlying market index. The most popular ETFs are constructed to mirror the performance of major market indexes like the S&P 500 or the NASDAQ 100. The underlying holdings in the ETF are put together so that the ETF moves in the same direction and by nearly the same amount as the index the ETF is trying to emulate.

The underlying holdings of an ETF are the individual securities that make up the ETF. Rather than going out and buying all the individual stocks which make up the ETF, an investor can purchase the ETF on an exchange just like a stock. They would own a basket of stocks just by making a single transaction.

For example, the NASDAQ 100 ETF would be a basket of the 100 stocks which make up the NASDAQ 100 Index. Since the holdings in the ETF are identical to the index the ETF is tracking, the daily performance of the ETF should mirror the index it's following. So, the NASDAQ 100 ETF should have about the same daily performance of the NASDAQ 100 Index. The underlying index is the index an ETF is tracking the performance of or mirroring. Here, the underlying index would be the NASDAQ 100.

Leveraged ETFs take this one step further. Rather than have a basket of stocks that attempt to mirror the performance of an index, leveraged ETFs use derivatives in order to multiply the daily return of the underlying index they're tracking. Leveraged ETFs will buy futures contracts to gain two-times or three-times the daily move of the underlying index. It is this use of derivatives which adds risks to leveraged ETFs that are not present in more traditional ETFs (which just hold individual stocks). Just like traditional ETFs, leveraged ETFs can be bought and sold on the stock exchange each day. You can trade leveraged ETFs like traditional ETFs or any stock.

Decay, Risk, and Volatility

One major factor seen in leveraged ETFs is decay. This decay is a function of the math behind having a multiplier. Let's use the example of two ETFs. The first, ABC, is an ETF that tracks the Big Index. The second, XYZ, is a leveraged ETF that returns two times the Big Index. Both the ABC and XYZ ETFs start off trading at $10 per share. Day 1, the Big Index is up 25%. The next day, the Big Index drops 20%.

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