Leveraged ETFs explained: How do they work?

What are leveraged ETFs

Leveraged ETFs are a special type of exchange-traded fund that uses borrowed money or financial instruments (like options, futures or swaps) to amplify the daily performance of an underlying index.

Unlike traditional ETFs that track an index passively, leveraged exchange-traded funds (ETFs) use derivatives, swaps and futures contracts to magnify gains or losses.

For example, consider a 2x leveraged ETF tracking the S&P 500. If the S&P 500 goes up by 1% on a given day, this ETF is designed to increase by roughly 2%. Conversely, if the index falls by 1%, the ETF typically drops by about 2%.

Additionally, the direction of movement of inversely leveraged ETFs differs from that of their underlying index. They are valuable for traders who want to profit from market drops because a -2x or -3x inverse leveraged ETF seeks to provide two or three times the inverse return of the index.

However, because these funds reset their leverage daily, their performance over longer periods can differ significantly from simply doubling the index’s return. The compounding effect during volatile periods can lead to outcomes that are much better or worse than expected. This makes leveraged ETFs suitable mainly for short-term trading rather than long-term investing.

This feature makes leveraged ETFs different from traditional ETFs, which track the performance of an underlying asset without amplification.

How do leveraged ETFs work in crypto?

A leveraged crypto ETF works like a magnifying glass for your cryptocurrency investment. It uses borrowed money or derivatives to amplify the daily returns of an underlying crypto asset such as Bitcoin (BTC). 

For example, if you invest in a 2x leveraged crypto ETF and Bitcoin’s price increases by 1% in one day, the ETF is designed to increase by about 2%. But if Bitcoin falls by 1%, the ETF will likely drop by around 2%.

Now let’s understand the steps involved:

• Choose the crypto asset: First, you pick the crypto you want to track. Let’s say it’s Bitcoin. The ETF is like a basket that holds Bitcoin, but instead of just tracking its price, it’s designed to do more.
• Borrow funds or use derivatives: Here’s where things get more interesting. The ETF borrows money or uses financial tools like options or futures to get extra exposure to Bitcoin. This means it’s not just buying Bitcoin outright; it’s leveraging its position.
• Set the leverage factor: Now, to make things exciting, the ETF will multiply the daily return of Bitcoin. If Bitcoin goes up by 1%, a 2x leveraged ETF would aim to double that return to 2%. Or, if you pick a 3x leverage, it could aim for a 3% move for every 1% change in Bitcoin.
• Daily reset: The ETF resets itself every day. So even though it’s aiming to double or triple Bitcoin’s returns, it only applies that leverage to that day’s performance. This means it’s not adding up over the long term; each day is a fresh start.
• Amplified gains and losses: Here’s the kicker: If Bitcoin goes up, you get those amplified gains. For example, a 1% gain in Bitcoin could mean a 2% gain in the 2x ETF. But if Bitcoin drops by 1%, that same ETF would lose 2%. So it works both ways — fast gains and fast losses.

How to trade leveraged ETFs in crypto market

Trading leveraged ETFs in the crypto market can be a high-risk, high-reward strategy, but with the right approach, it can be profitable.

Leveraged ETFs are primarily bought by active traders, institutional investors and those seeking short-term gains or hedging strategies, with the SEC regulating their structure and ensuring transparency. They are not suitable for long-term investors due to their complexity and potential for high risk.

Let’s understand the steps involved in trading leveraged ETFs in the crypto market:

Step 1: Choose a crypto exchange

• You’ll need to pick a platform that offers leveraged ETFs in crypto. Some exchanges like Binance and Kraken offer crypto-focused leveraged ETFs.
• These platforms allow you to trade both traditional crypto and leveraged products like 2x or 3x ETFs.

Step 2:  Set up an account

Step 3: Fund your account

• Deposit fiat (USD, EUR) or cryptocurrency (like BTC) into your account. If you want to avoid high fees, consider depositing crypto instead of fiat.

Step 4: Pick your leveraged ETF

• Once your account is funded, choose the leveraged ETF you want to trade. For example, if you’re bullish on Bitcoin, you can choose a Bitcoin ETF with 2x or 3x leverage.
• The higher the leverage (2x, 3x, etc.), the higher the potential gain or loss.

Step 5: Select your trading strategy

• Day trading (for short-term gains): Since leveraged ETFs reset daily, they’re ideal for short-term trades. Look for price movements in Bitcoin or your chosen asset and use these daily fluctuations to make a profit.
• Scalping: This strategy involves making many small, quick trades to capitalize on micro price changes. This works well with leveraged ETFs as you amplify every little move in the market.
• Trend following: If you spot a strong upward or downward trend, you can use a leveraged ETF to capitalize on that momentum. Remember that leveraged ETFs can be volatile in the short term.

Step 6:  Set stop-losses and take profits

• Always use stop-loss orders to protect yourself from large losses. For example, if Bitcoin drops by 5%, your ETF might lose 10% or more. A stop-loss will help cut your losses if things go wrong.
• Similarly, set a take-profit level to lock in your gains before the market turns against you.

In addition to the above steps, you must monitor your positions due to the daily reset mechanism. Leveraged ETFs can swing wildly, so ensure you’re actively managing your trades, especially in volatile markets like crypto.

Leveraged ETFs in bull and bear markets

Leveraged ETFs can be suitable in both bull and bear markets, but they come with distinct risks and opportunities depending on market conditions. 

In bull markets (rising prices)

• Potential for amplified gains: Leveraged ETFs shine in a bull market. If the underlying crypto (like Bitcoin) rises, a leveraged ETF with 2x or 3x leverage can multiply those gains. For example, if Bitcoin goes up by 5% in a day, a 2x leveraged ETF could potentially provide a 10% return.
• Short-term focus: Leveraged ETFs are designed to magnify daily returns, so they work best for short-term trades. In a bull market, leveraged ETFs can offer swift, significant profits if you’re quick and know the market trends.

However, in bull markets, sudden reversals can wipe out profits. Even if the market is trending up, unexpected pullbacks can trigger losses. This makes timing your entry and exit crucial.

In bear markets (falling prices)

• Amplified losses: In bear markets, leveraged ETFs can be risky. If Bitcoin or another crypto asset falls, a 2x or 3x leveraged ETF will experience amplified losses. For example, a 5% drop in Bitcoin could result in a 10% or 15% loss in the ETF.
• Shorting opportunities: Some leveraged ETFs are designed to profit from a falling market (inverse ETFs). In a bear market, these could be more suitable if you’re looking to profit from declines. But like in bull markets, these ETFs require careful timing to avoid big losses due to the daily reset mechanism.

Bear markets are often volatile, with many sudden price swings. Leveraged ETFs amplify these fluctuations, which can be difficult to navigate for anyone without careful risk management.

Advantages of leveraged ETFs

Leveraged ETFs offer several advantages for traders, including amplified returns, effective capital use, high liquidity, diversification and hedging opportunities.

Let’s understand these benefits in more detail:

• Amplified returns: It might be tempting to have the chance to earn two or three times the return of the underlying index.
• Effective use of capital: Without making big financial commitments, investors can have substantial exposure to market fluctuations.
• Liquidity: For active traders, leveraged ETFs provide significant liquidity by trading on major exchanges.
• Diversification: Leveraged ETFs, like traditional ETFs, offer exposure to a variety of securities, lowering the risk associated with particular stocks.
• Hedging opportunities: Leveraged ETFs provide investors with a way to protect themselves from declines in other assets.
• Access to bull and bear markets: Investors can benefit from rising or falling markets by choosing bullish or inverse leveraged ETFs.

Risks of leveraged ETFs

Leveraged ETFs come with heightened risks such as enhanced volatility, compounding effects, value decay in sideways markets, higher fees and margin call risks, making them unsuitable for long-term holding.

Let’s look at the risks associated with leveraged ETFs to understand why they might not be suitable for all investors:

• Enhanced volatility: These ETFs are riskier than conventional ETFs since the same leverage that increases gains also amplifies losses.
• Compounding effect: As a result of daily rebalancing, returns may gradually diverge considerably from the anticipated multiple.
• Decay in sideways markets: Even if the index stays comparatively stable, leveraged ETFs may lose value during bumpy market moves.
• Higher fees: These ETFs have higher expense ratios, which lower net returns because of the difficulty of maintaining leverage.
• Not suitable for long-term holding: Since leveraged ETFs are intended for short-term trading, holding them for extended periods may result in a marked underperformance compared to expectations.
• Margin call risks: Market fluctuations have the potential to cause margin calls for investors trading on margin using leveraged ETFs, which might result in forced liquidations and large losses.

Tax implications of leveraged ETFs

Leveraged ETFs are less tax-efficient due to daily rebalancing, with potential tax implications like higher short-term gains and wash sale restrictions.

Therefore, before adding leveraged ETFs to their portfolios, investors should be aware of these implications:

• Short-term vs. long-term gains: Leveraged ETF trades are taxed at the investor’s ordinary income tax rate, which is higher than the long-term capital gains rate because the majority of these trades are short-term.
• Wash sale rule: Leveraged ETF traders should be aware of the wash sale rule, which can prevent tax deductions for losses if the funds are repurchased within 30 days.
• Tax treatment of derivatives: Leveraged ETFs that utilize futures contracts (a type of derivative), classified under IRS Section 1256, benefit from a favorable tax treatment known as the 60/40 rule. This rule allocates 60% of the gains or losses to long-term capital gains and 40% to short-term capital gains, regardless of the holding period. However, it’s important to note that this tax treatment applies to the ETF’s underlying futures contracts, not necessarily to the ETF’s overall performance.