Introduction to Leveraged Exchange-Traded Funds (ETFs)
Exchange-traded funds (ETFs) enjoy popularity in the financial markets, offering a variety of options including those linked to stocks, domestic indices, and global indices. ETFs mimic the performance of their respective indices, potentially amplifying gains. Nonetheless, this also means that losses can multiply, introducing a high level of market risk.
Leveraged ETFs, with their distinct attributes, are attractive to experienced traders and sophisticated fund managers, but are generally unsuitable for novice investors due to their higher risk profile. This article will explain the basics of Leveraged ETFs and its pros and cons in the crypto markets.
Understanding Leveraged ETFs
A Leveraged ETF is a popular financial derivative in traditional markets that tracks the yield rate of an underlying asset (e.g., BTC) with a specified multiplier (e.g., 3 times). For instance, if BTC gains 1%, a 3 times leveraged ETF will increase by 3%, while a -3 times leveraged ETF will decrease by -3%. This type of ETF is perpetual, with no settlement day, making it immune to liquidation risks. Investors can buy or sell it on the secondary market without needing margin.
The value of the leveraged ETF is calculated in USDT, and its trading resembles spot trading. Essentially, it’s a fund of shares tied to the underlying asset’s returns with a multiplier. Investors can amplify their returns compared to the underlying asset.
If the underlying asset fluctuates beyond a certain threshold, the fund manager rebalances the fund to limit losses. In short, trading leveraged ETFs allows investors to magnify the returns of the underlying assets, and they are not subject to liquidation risks due to control measures taken by the fund manager.
Price Mechanism of Leveraged ETFs
The price of a leveraged ETF is tied to the performance of the underlying asset, but it can deviate from its net asset value (NAV), especially in volatile markets. This divergence creates a variety opportunities for traders. To maximize profits and minimize losses, traders need to be mindful of the relationship between the ETF’s market price and its NAV.
NAV is essentially the fair price of the leveraged ETF in the secondary market. In volatile market conditions, the market price may temporarily deviate from the NAV, creating opportunities for traders to profit by taking advantage of these pricing differences. However, it’s crucial for investors to set order prices close to the NAV to avoid significant losses.
Rebalance Mechanism of Leveraged ETFs
To prevent the divergence of portfolio leverage from the agreed ratio, leveraged ETFs employ a rebalancing mechanism. Typically, rebalancing occurs at 00:00 (UTC+8) every day. If the underlying asset’s price moves significantly, exceeding a predetermined threshold (usually set at 15% for 3x leveraged ETFs), the fund manager will rebalance the ETF to control risk. Importantly, rebalancing is performed only for the leveraged ETF product that has incurred losses in the volatile market.
For example, if BTC experiences a 15% increase, the BTC3S product (a -3x leveraged ETF) will be rebalanced, but BTC3L (a 3x leveraged ETF) will not. The goal is to ensure that losses are limited and that the leveraged ETFs continue to track the performance of the underlying asset.
The Leverage in Leveraged ETFs
Leveraged ETFs utilize derivatives, such as options contracts, to magnify exposure to a specific index or asset. These ETFs do not amplify annual returns but instead track daily changes. Options contracts provide investors with the flexibility to trade the underlying asset without the obligation to buy or sell it. While options have upfront premiums, they enable investors to control larger positions, potentially amplifying gains.
Additionally, leveraged ETFs may employ portfolio leverage, which involves borrowing to acquire more shares of securities, further increasing the potential for gains. This leverage allows investors to benefit from the daily fluctuations of the underlying asset.
Pros and Cons of Leveraged ETFs
Pros
- Potential for Significant Gains: Leveraged ETFs offer the opportunity to achieve returns that exceed the performance of the underlying index, making them appealing to traders looking for substantial profits.
- Variety of Securities: Investors have access to a wide range of leveraged ETFs tied to different assets and indices, providing flexibility in their trading strategies.
- Profiting in Declining Markets: Inverse leveraged ETFs enable investors to make money in bearish markets or during declines in the underlying index.
Cons
- Potential for Significant Losses: The amplification of returns works in both directions, and leveraged ETFs can result in substantial losses that surpass the losses of the underlying index.
- Higher Fees: Leveraged ETFs typically come with higher management fees and expense ratios compared to traditional ETFs, which can eat into potential gains.
- Not Long-term Investments: Due to the nature of daily rebalancing and options contracts, leveraged ETFs are not suitable for long-term investment strategies.
How are futures contracts used in leveraged ETFs?
Leveraged ETFs use futures contracts to amplify daily exposure to a specific index. They can be positive or inverse ETFs, and their goal is to magnify daily changes, not annual returns. For example, a 2:1 leveraged ETF means that for each dollar of investor capital, an additional dollar of debt is invested. If the underlying index gains 1% in a day, the fund theoretically gains 2%, though actual returns are lower due to fees and transaction costs. Conversely, if the index drops 1%, the fund incurs a 2% loss.
Disclaimer: The opinions expressed in this blog are solely those of the writer and not of this platform.
