From our previous article on leveraged exchange-traded funds (ETFs), “What the Heck are Leveraged ETFs?” we started to learn and dive into what it means to have leverage on an asset or index, some of the risks and rewards of the strategy, and how to learn a lot more about them. Let’s explore the reasoning and practical applications behind leveraging and what to consider for your trading activity.
Let’s use a hypothetical situation to illustrate how it works. If you’re fairly certain that the value of the S&P 500 is going to go up over the six months to a year, you might consider buying a plain vanilla ETF that tracks the index. If there’s a moderately good chance of a value increase, you probably don’t want to take on too much risk, so the actual value of the index might be the best plan.
But what if you were confident the value is going to go up by a solid amount over the next couple of days or week? And let’s say once you researched the risks of daily compounding, you were willing to take on more risk in the short term. You might consider using a leveraged ETF like the Direxion Daily S&P 500® Bull (SPXL) 3X Shares to gain greater exposure and seek to make more money than buying the plain vanilla index fund/ETF would allow.
Bigger Rewards, Bigger Risks but not the Biggest
However, if you’re mistaken and the S&P 500 plummets, it will be more costly than if you simply bought the index fund/ETF asset. Additionally, because of rebalancing and other important factors of leveraged ETFs, it can cost more than just the stated multiplier, especially if held over longer periods of time. Ultimately, this could be less risky than actions like trading on margin and short selling. You don’t owe money and still were able to punch above your monetary weight with no form of unlimited loss obligation.
In the hypothetical case of a trader who was expecting the S&P 500 to go down, he could short an index fund or ETF but would need to buy it back at some point, allowing for the possibility of unlimited loss if the price continues to rise. Using the Direxion Daily S&P 500® Bear (SPXS) 3X Shares to create a position that is inverse to the S&P 500’s value without directly shorting it is one way to avoid this risk.
In any scenario, it is important for investors and traders to do their homework and understand the risks, but for some, using leverage to their advantage might be a way to turn small trends in the index into big gains.
For more in-depth explanations of technical terms around these ETFs, what they mean, and how they can affect you, check out the explainer page.
Terms leveraged ETF investors should know:
Beta – A measure of the systematic variability of a security or a portfolio in relation to a target index. A beta of more than 1.00 indicates that the security or portfolio would have higher volatility than the index; a beta of less than 1.00 indicates lower volatility.
Counterparty – In financial service terms, counterparty can refer to brokers, investment banks, and other securities dealers that serve as the contracting party when completing “over-the-counter” securities transactions. The term is generally used in this context in relation to “counterparty risk,” which is the risk of monetary loss a firm may be exposed to if the counterparty to an over-the-counter securities trade encounters difficulty meeting its obligations under the terms of the transaction.
Futures Contract – A contract, traded on a futures exchange, to buy or sell a standardized quantity of a specified commodity of standardized quality (e.g., a “basket” of corporate equities [“stock indices”] at a certain date in the future, at a price (the futures price) determined by the market price at the time of the purchase or sale of the contract.
INAV (the Intraday NAV) – Used as a reference for an ETF’s underlying value during trading hours, prior to market close. In many cases, the ETF will trade at a premium or discount to the NAV due to various factors, including supply and demand. Calculating INAV prior to purchasing an ETF allows you to determine whether you are purchasing it at a premium or a discount to the ETF’s NAV.
Secondary Market – The financial market for trading of securities that have already been issued in an initial private or public offering. New ETF shares are created in the primary market in large lots called creation units by financial professionals called Authorized Participants. Once these shares are created, they become available for purchase to all investors in the secondary market.
Swap – A derivative in which two counterparties agree to exchange one stream of cash flows for another stream. These streams are called the legs of the swap.
The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties. Consequently, swaps can be used to create unfunded exposures to an underlying asset, since counterparties can earn the profit or loss from movements in price without having to post the notional amount in cash or collateral.
An investor should carefully consider a Fund’s investment objective, risks, charges, and expenses before investing. A Fund’s prospectus and summary prospectus contain this and other information about the Direxion Shares. To obtain a Fund’s prospectus and summary prospectus call 646-760-3323 or click here. A Fund’s prospectus and summary prospectus should be read carefully before investing.
The “S&P 500 Index” is a product of S&P Dow Jones Indices LLC (“SPDJI”), and has been licensed for use by Rafferty Asset Management, LLC (“Rafferty”). Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); and these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Rafferty. Rafferty’s ETFs are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of the S&P 500® Index.
Investing in a Direxion Shares ETF may be more volatile than investing in broadly diversified funds. The use of leverage by a Fund increases the risk to the Fund. The Direxion Shares ETFs are not suitable for all investors and should be utilized only by sophisticated investors who understand leverage risk, consequences of seeking daily leveraged, or daily inverse leveraged, investment results and intend to actively monitor and manage their investment.
Direxion Shares Risks – An investment in the ETFs involves risk, including the possible loss of principal. The ETFs are non-diversified and include risks associated with concentration that results from an ETF’s investments in a particular industry or sector which can increase volatility. The use of derivatives such as futures contracts and swaps are subject to market risks that may cause their price to fluctuate over time. The ETFs do not attempt to, and should not be expected to, provide returns which are a multiple of the return of their respective index for periods other than a single day. For other risks including leverage, correlation, daily compounding, market volatility and risks specific to an industry or sector, please read the prospectus.
Distributor for Direxion Shares: Foreside Fund Services, LLC.