Leveraged ETF Trading Strategy (Backtest And Example)

Last Updated on January 11, 2023

Investors are always looking for ways to magnify their returns, and leveraged ETFs seem to promise that, which is why they are becoming very popular among both institutional and retail investors. Ever since their emergence, leveraged ETFs have received a lot of media attention that an uninformed may think they are all gains and no losses. What are leveraged ETFs, and what is a leveraged ETF strategy?

Leveraged ETF trading strategy refers to a short-term investment method that involves trading leveraged ETFs exchange-traded funds that use financial derivatives and debt to amplify the returns of an underlying index. There are hundreds of leveraged ETFs across different asset classes and industry sectors, and they can be double-leveraged, triple-leveraged, or inverse ETFs.

In this post, we answer some questions about the leveraged ETF trading strategy. at the end of the article, we make an example and a backtest.

What is leveraged ETF trading strategy?

Leveraged ETF trading strategy refers to a short-term investment method that involves trading leveraged ETFs — exchange-traded funds that use financial derivatives and debt to amplify the returns of an underlying index.

Unlike the traditional exchange-traded fund that typically tracks the securities in its underlying index on a one-to-one basis, a leveraged ETF may aim for a 2:1, 3:1, or an inverse of the index. Thus, there are hundreds of leveraged ETFs across different asset classes and industry sectors, and they can be double-leveraged, triple-leveraged, or inverse ETFs.

With a 3:1 or triple-leveraged ETF strategy, the aim is to return three times the profit the index makes in a day, but when there is a loss, it also magnifies it. An inverse ETF profits when the underlying index is declining and loses when the index is gaining. While the directly leveraged ETFs are used to aim for more profit in a bullish market, the inverse ETFs can be used to short the index in a bear market.

What is a leveraged ETF?

A leveraged ETF is an exchange-traded fund that uses debts and financial derivatives products to amplify the daily returns of an underlying index. Leveraged ETFs trade on the stock exchanges, just like conventional ETFs. An ETF is a fund that invests in a basket of securities and often tracks the performance of an index. With a traditional ETF, the underlying index (say S&P 500 Index) is tracked on a one-to-one basis — if the S&P moves 1% for the day, the ETF will also move by 1%.

A leveraged ETF, on the other hand, may aim for a 2:1 or 3:1 ratio — that is, if the S&P moves 1% for the day, the ETF will also move by 2% or 3%, as the case may be. The level of gain depends on the amount of leverage used in the ETF. In financial trading, leveraging is an investing strategy that uses borrowed funds to buy options and futures to increase the impact of price movements.

Leverage is a double-edged sword meaning it can lead to significant gains, but can also lead to significant losses when the underlying index moves in the opposite direction. For example, if the underlying index falls by 1%, a 3:1 leveraged ETF would fall by 3% or more. Moreover, the management fees and transaction costs associated with leveraged ETFs can diminish the fund’s return and also increase losses. Leverage is a double-edged sword meaning it can lead to significant gains, but it can also lead to significant losses. This is why you should be aware of the risks associated with leveraged ETFs since the risk of losses is far higher than those from traditional investments.

What is the most effective leveraged ETF trading strategy?

The most-effective leveraged ETF trading strategy is short-term trading — day trading or swing trading at most. Leveraged ETFs are best used when you wish to speculate on an index or to take advantage of the index’s short-term momentum.

Owing to the high-risk and high-cost structure of leveraged ETFs, they are not good for long-term investments. The reason why leveraged ETFs are not good for long-term investments is that the derivatives used to create the leverage are not long-term investments. Your best bet is to hold positions in leveraged ETFs for just a few days at most. If you can day trade, day trading is the best strategy because you gain the day’s return and don’t get involved in the daily rebalancing that follows.

What risks should be considered when trading leveraged ETFs?

The main risk is that, in as much as leverage increases profits when the market goes up, it magnifies losses when the market goes the wrong side. Thus, adverse price movements can have dreadful consequences when trading leveraged ETFs.

If the underlying index declines by 2% in a day, a 3:1 leveraged ETF can lose more than 6%. To manage such risks, you have to be ready for them. You may use a stop loss order or diversify across different markets and different ETFs to offset the losses on the red days. For example, you can trade both the directional leveraged ETFs and inverse ETFs.

What are the tax implications of leveraged ETF trading strategies?

Profits from trading ETFs are taxed the same way profits from stock trading are taxed — short-term trading profits are taxed according to short-term capital gain tax rates, while long-term profits are taxed based on long-term capital gain rates.

So, if you hold a leveraged ETF for more than a year, you are taxed at the long-term capital gain rate, which is often cheaper. However, given the nature of leveraged ETFs, you don’t want to hold them that long because of the effects of volatility decay.

If you are trading leveraged ETFs, you are probably going to practice short-term trading — day trading or swing trading. So, expect to be taxed based on the short-term capital gain tax rate, which is the same rate applied to your ordinary income. However, only net capital gains are taxed, as capital gains can be offset by capital losses before applying the tax rates.

What are the advantages and disadvantages of leveraged ETFs?

There are some merits to trading leveraged ETFs when done the right way. These are some of them:

  • Leveraged ETFs offer the potential for significant gains that exceed the underlying index, as they amplify daily returns — you can help you generate outsized returns and hedge against potential losses.
  • They offer a wide variety of securities to trade using leveraged ETFs.
  • You can make money when the market is declining using inverse leveraged ETFs.
  • Shares of leveraged ETFs are traded in the open market like a stock.

There are many demerits as well. Here are some of them:

  • Leveraged ETFs can lead to significant losses that exceed the underlying index, as amplified daily returns can trigger steep losses in short periods of time, and a leveraged ETF can lose most or all of its value.
  • They have higher fees and expense ratios as compared to traditional ETFs.
  • Since some leveraged ETFs are not heavily traded, your ability to buy or sell shares in a leveraged fund may be constrained.
  • Given that they utilize derivatives to boost returns, leveraged ETFs are less likely to closely track the underlying index over the long term, and as such, leveraged ETFs are not long-term investments.

How can one measure the performance of leveraged ETFs?

You measure the performance of leveraged ETFs using most of the same parameters you use to measure performance in other assets, such as the Sharpe ratio, Jensen’s alpha, and the appraisal ratio (also known as the Treynor Black ratio).

  • Sharpe ratio: This compares the return of an investment with its risk. It divides the difference between an asset’s return and the risk-free rate of return by the standard deviation of returns over a given period. The ratio presents a mathematical expression of the insight that excess returns over a period of time may signify more volatility and risk, rather than investing skill.
  • Jensen’s alpha: This is a risk-adjusted performance measure that represents the average return on a portfolio or investment, above or below that predicted by the capital asset pricing model (CAPM), given the portfolio’s or investment’s beta and the average market return.
  • The appraisal ratio: This shows how many units of active return the manager is producing per unit of risk. It is gotten by comparing the fund’s alpha, the amount of excess returns the manager has earned over the benchmark of the fund, to the portfolio’s unsystematic risk or residual standard deviation.

What strategies should be used to reduce the risk of trading leveraged ETFs?

Risk is a necessary part of trading. Without risks, there would be no returns. However, you need to manage risks well to stand a chance of making profits. There are a few ways you can do that when trading leveraged ETFs. First, you may use a stop loss order to limit how much you can lose in any trade. Since the asset is leveraged, any loss in the underlying index is magnified. To limit your losses, you can set a stop loss order.

Another way to manage risks is to diversify across different markets and different ETFs to offset the losses on the red days — for example, you can trade both the directional leveraged ETFs and inverse ETFs.

How can one identify potential opportunities in leveraged ETFs?

You start by finding out the components of the leveraged ETFs you want to trade and the market index they track. Next, you perform a fundamental analysis to know the factors and conditions that move both the component stocks and the index as a whole.

How do market conditions affect the performance of leveraged ETFs?

The condition of the market affects the way the underlying index moves. Since the leveraged ETFs track the movement of the index, at least over the short term, market conditions also affect them. For example, if the market is bullish, the underlying index is likely to risk and so is the ETF.

What strategies should be used to select the best leveraged ETFs?

Focus on the most-trades leveraged ETFs. That way, you are sure there would be enough liquidity when you want to get out of your position.

What factors should be taken into account when setting up a leveraged ETF trading strategy?

Factors to consider when selecting the best leveraged ETF to trade include:

  • Volatility: Since the asset is leveraged, it’s better to trade the one whose underlying index is the least volatile.
  • Liquidity: Be sure to trade only ETFs with good liquidity so you can easily get into and out of position.
  • Management fees and transaction costs: Look for ETFs with the least fees.

What advantages do leveraged ETF trading offer over traditional trading strategies?

Leveraged ETFs magnify the profit potential when the underlying index is rising. A traditional ETF that is tracking the S&P 500 Index would offer close to 1% profit when the index makes a 1% gain, but a leveraged ETF would offer 2% or 3%, depending on the designed leverage factor.

How can one evaluate the risks associated with leveraged ETF trading?

You can make use of the usual risk-assessment ratios using in evaluating other assets. Common examples include the Sharpe ratio, Jensen’s alpha, and the appraisal ratio. Given the leveraged nature of the asset, Trenor’s ratio may not capture the risks correctly.

What criteria should be used to select leveraged ETFs?

The most important criteria to use include:

  • Liquidity of the fund
  • Management fees and transaction costs
  • The volatility of the underlying index

How can one assess the potential return on investment of leveraged ETFs?

You can use common tools used for evaluation funds, such as the Sharpe ratio, Jensen’s alpha, and the appraisal ratio.

How can one adjust a leveraged ETF trading strategy to changing market conditions?

You can trade a diversified portfolio of ETFs, with traditional ETFs, directly leveraged ETFs, and inverse ETFs. Also, you have to track the market condition with the volatility index to know when to rebalance your portfolio and give more weight to inverse ETFs and traditional ETFs if the market is bearish.

Leveraged ETFs and volatility decay

Leveraged ETFs amplify losses, and any loss is so devastating when amplified. Over a long-term period, the market can be bearish, with the underlying index losing a significant percentage. With a leveraged ETF, the loss can be magnified. For example, if the S&P 500 losses 35% in a bear market, a 3:1 leveraged ETF would wipe out your entire investment in the fund.

Leveraged ETF Trading Strategy Backtest

A complete backtest of a leveraged ETF strategy with strict trading rules and settings is coming shortly.

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