Guide to Leveraged ETFs

I play leveraged and inverse ETF shares quite a lot, I personally prefer to swing trade those than options on the underlying as I find them slightly safer than options with no time limit or theta decay. But the truth is, I never truly understood the technical of how leveraged ETFs worked. Alas, this is the point of this post. I was going to combine inverse ETFs and leveraged ETFs together, but in researching this post and doing my own analysis, it’s too much. Thus, this post will just focus on leveraged ETFs and I will make an attempt at an inverse one later.

I will look at:
What are leveraged ETFs;
How do they work;
How they Compare to the Underlying
Options and Leveraged ETFs
Calculating Targets on Leveraged with the Underlying (of course, this is a post from me, so you can EXPECT to be pulling out that calculator ;) )
Concluding remarks and Should you invest in leveraged over Underlying?

What are leveraged ETFs?

- An aggressively managed investment vehicle that uses financial derivatives and debt to amplify its returns and exposure on an underlying index.
- It differs from a general ETF in how it tracks its securities and underlying index. An ETF is generally a 1:1 ratio, whereas a leveraged ETF can be 1:3 or 1:2. Its extent will be listed in its time (i.e. SPXL: Direxion Daily S&P 500 Bull 3X Shares is 1:3 ratio, i.e. the 3 X listed in the title).
How do leveraged ETFs Work?
Let’s use SPXL as an example which tracks the S&P 500 (or SPY ETF)
- It will use financial products such as options as well as debt to magnify each 1% gain on the S&P 500 and thus increase its exposure to the index.
- The augmentation of the gain is contingent on the amount of leverage used in the ETF which is the result of borrowing funds to buy options/futures and underlying to increase the extent of its gains
- Because leveraged ETFs are aggressively managed with the portfolio managers and traders constantly borrowing, buying and selling multiple different investment vehicles, management fees and transaction costs can be pricey. Thus, this can take away from the ETF’s actual return, which we will look at next in “How they Compare to the Underlying”
- Because the leveraged ETF is so aggressively managed and is constantly buying and selling investment vehciles, it can be difficult for the ETF to get its quoted ratio (for example SPXL is 1:3) and there are sometimes variances in how much it actually can track at a point in time. This is something we can actually see and measure via statistics and I will make an attempt at so doing in this post.

How leveraged ETFs compare to the underlying?

I am going to break this down. Essentially the questions I want to answer with this is, what is the extent of the relationship between the underlying (the index or thing that the leveraged ETF is tracking) measured as a statistical correlation Pearson value (which measures the degree of the relationship). As well, what is the extent of return on a leveraged ETF vs the underlying. To answer this, I will use SPXL.

Firstly, what is the statistical relationship between leveraged ETFs and the underlying? If there was a perfect 1:3 or 1:2 relationship, then we would expect to see a Pearson correlation of 1. Anything below 1 means that there is an imperfect relationship and there is some decay in the leveraged ETF’s ability to track the underlying fully. Running this analysis for SPY and SPXL, QQQ and TQQ and DIA and UDOW, yields the following R values respectively: 0.969 (SPY/SPXL), 0.975 (QQQ/TQQQ), 0.912 (DIA/UDOW). The relationship is very strong, there is no denying that this is a strong and statistically significant relationship. But! Its not perfect and not what I would expect if the leveraged was truly matching the underlying at a perfect ratio.

And the last question “the extent of return?” I have actually seen people ask “why not just invest in the leveraged ETF instead of the ETF itself (the 1:1 ratio ETF)? And you know what? That is actually a really legit question. Why not? Well, lets look at SPXL and SPY.

If you would have invested in SPY on March 22nd, 2021, lets say for its close price of 392.59 and sold on March 22nd, 2022 for its close price of 449.59, your annualized return for that year would be 14.52%, or a 13% difference between the starting price and the ending price (we will assume for simplicity that, that is our 1:1 ratio). If you did this same thing for SPXL, sold at the same time and at its close price (82.71 to 118.37), your annualized return would be 43.11%, or a roughly 35% difference (a 1:3 ratio would be roughly 33% difference), so not bad! But is it 1:3 exposure?

Again, keeping things simple, if we set our positive exposure as the percent change over time (I am doing this just to keep things as simply and as easily as possible) then this is roughly a 1:3 ratio indeed, slightly lower though. We would expect to augment positive exposure by 3 X, thus we would expect a percent difference to be 3 X the percent difference of the underlying. This means we would expect to see a percent different on SPXL of around 39%. 35% is fairly close, but you do see how there was some falling short of a true 1:3 ratio.

What about if you invested in SPY on March 10 of 2015. Assuming you bought for its close price, you would pay 204.98 to buy SPY. Then, say you sold on March 10th of 2022 for its close price of 425.48, you would have sold for 425.48. This would equate to an annualized return rate of 11% or a % difference of 69.95%. For SPXL, assuming the same, your annualized return rate would be 24.59% with a percent different of 129.03%. This indeed falls short of a 3 X positive exposure, as we would expect to have seen roughly a 209% change over time, meaning 1:3 ratio. SPXL did fall short of this.

Options and leveraged ETFs

I have seen some advocating buying of leveraged ETFs options over the options of the underlying. Is this a good idea?
Well, unfortunately, I cannot fully answer this question objectively, because there are a lot of pragmatic circumstances you must take into account when playing options. These pragmatic circumstances are namely liquidity and spreads. I can speak from experience, that liquidity and spreads are not great on leveraged ETFs and this is why I generally do not recommend playing options on leveraged ETFs. You generally will risk having trouble liquidating your position and getting out at asking price.
Furthermore, you are leveraging upon leveraging. Based on the results of the previous section, you can conceptualize SPXL or any leveraged ETF as having an inherent ‘theta’ type decay, as it doesn’t truly follow at its desired ratio, likely owning to the fact that managing a leveraged ETF is a costly process, comes with bigger losses and comes with more fees. Thus, you are essentially accepting more risk by playing options on leveraged ETFs. And because leveraged ETFs are difficult to predict in terms of price points they will reach compared to the underlying (something we will discuss more in depth in the next part), it is difficult to predict your profit potential. You can use a service like optionsprofitcalculator website; however, its difficult to know what price for sure the stock is going to hit compared to the underlying. You would likely need to do separate analysis on the leveraged ETF over the underlying.

In general, I recommend avoiding options on any leveraged ETF. The greeks are better but the profit taking potential is objectively lower based on my own analysis. Some of the concerns expressed by others over buying options for the underlying include theta decay and price. However, the savvy options trader can effectively manage these concerns by analyzing the underlying, planning their entries appropriately and giving themselves more than enough time for their prediction to come to fruition.

But as always, this needs to be a personal choice based on your own risk assessment and financial goals.

Calculations!

My favourite, calculations! Have you ever wondered if you can convert SPY price into SPXL price? Well friends, you can… sort of, but not really.

Remember, there is inherent, I conceptualize it as decay, within SPXL or any leveraged ETF and thus you are not going to get a prefect 1:3 ratio. We see this with a Pearson R being less than 1. Thus, there is a higher range of error than I would expect should the stock truly follow the underlying at a perfect 1:3 ratio. But I will still share with you my tips, tricks and know how of calculating target prices for SPXL, QQQ & UDOW. But just undertand, I don’t do this personally because it doesn’t work well, but I want to just nail down the fact that leveraged ETFs don’t actually follow what they track perfectly, and the fact we struggle to calculate the expected prices between the two show that they really struggle to maintain a perfect balance.

SPY to SPXL (Error of +/- 7 points)

SPY Price x 0.4114 – 71.297 = SPXL Price

Example

SPY Closed at 411.34 on Friday
411.34 x 0.4114 – 71.297
= 97.93 SPXL close price

Actual was 88, 97, within what I would expect based on the error.
As you see, its not perfect at all and its not at all what I would expect if there was a true 1:3 relationship.

QQQ to TQQQ (Error of +/- 4.68)

QQQ Price x 0.254 – 31.188

Example:

QQQ Closed at 309.25 on Friday
309.25 x 0.254 – 31.188
= 47.36 TQQ

Actual 34.61 and not within the standard of error.

DIA and UDOW (Error +/- 6.32)

DIA Price x 0.321 – 37.897

Example:
DIA closed at 329.07 on Friday.
329.07 x 0.321 – 37.897
= 67.73

UDOW actual was 61.04, within what I would expect based on the error.

Conclusions

What to take away from this post. Let’s summarize:
- Leveraged ETFs use just that, leverage in the form of options, futures, derivatives, etc. to augment their exposure to the underlying
- Leveraged ETFs are not perfect in how they purportedly track the underlying as evidenced by the returns and Pearson correlation. This is likely owning to the high maintenance costs of managing a leveraged ETF and also to the fact that losses are also amplified for the holder and for the firm itself managing the ETF.
- I would recommend avoiding options on leveraged ETFs owning to liquidity issues, spread issues and the inability to accurately account for the likely price of the ETF based on the underlying.
- You can calculate a rough estimate of where the price may fall based on the underlying, but it is quite difficult to pinpoint where an inverse will fall based on the underlying because, again, its not truly able to match at a perfect ratio.

Should you Invest in an Inverse over the actual ETF?
Decide for yourself. Your annualized return rate would indeed be augmented, regardless of the decay. However, in addition to the risks of not perfectly tracking the underlying, there are also other risks that were not considered here, i.e. what if the firm managing the inverse ETF goes bankrupt, what if they decide to halt their program, etc. etc. This is beyond the scope of what I can cover in this post at this time! But I think there is sufficient details here for you to start making your own decisions!

Thanks for reading!
Leave a comment with your questions, comments and critiques!