I only trade the S&P 500’s leveraged ETFs in my medium-long term portfolio. Leveraged ETFs are an ideal financial product for traders to profit from their market outlook. Here’s why.
Leveraged ETFs have compounding.
Leveraged ETFs compound on themselves during a bull market. The more steady the rally, the more the leveraged ETFs compound on themselves.
This is exactly the opposite of ETF erosion.
Leveraged ETFs match the underlying market’s day-to-day returns. This means that a leveraged ETF will perform better than you think when its underlying market is going up.
Let’s assume that the market goes up 100% a year.
- The underlying market will go from 1, to 2, to 3, to 4, to 5.
- A 3x leveraged ETF will go up 300% a year. It will go from 1, to 4, to 16, to 64, to 256.
As you can see, the 3x leveraged ETF outperforms the underlying market by far more than 3x (256/5 = 50.1x outperformance). This is because the leveraged ETF compounds on itself.
Hence, leveraged ETFs magnify your returns exponentially when the trend is strong and on your side.
Of course it’s also important to sidestep big bear markets. Bear markets destroy leveraged ETFs due to erosion (see post).
Sidestepping “significant corrections” is not mandatory, but it’s nice to have. Significant corrections generally don’t cause a lot of ETF erosion. Erosion is only a massive problem during bear markets.
Leveraged ETFs allow you to beat most professional traders.
Here’s a simple strategy that most people don’t realize. Most traders are happy to achieve 10% a year. You know what simple strategy achieves 17% a year? Buying and holding a leveraged ETF for the U.S. stock market.
- The S&P 500 has yielded an average annual return of 7.8% from 1950-present.
- A 3x leveraged ETF – even after including bear market erosion – will average an annual rate of return of 16.4% from 1950-present!
A leveraged ETF will never lose all its value the way a futures contract or options will. This means that if all you did was buy and hold a leveraged ETF, you will significantly beat a buy and hold strategy.
Here’s what a hypothetical UPRO (3x S&P 500 ETF) will look like from 1950 to present.
Notice how erosion during bear markets has taken a significant bite out of UPRO’s value. That’s why you should know how to predict and avoid bear markets. But even then, UPRO still significantly beats buy and hold and the returns of most traders.
You can take advantage of erosion when shorting a leveraged ETF.
Leveraged ETFs will face erosion (lose value) when the market swings sideways for a long time or when the market is in a bear market. This means that by shorting a leveraged ETF, you can make money just from the erosion alone.
Let’s assume that you’re bearish on the market. You short a leveraged ETF. The market doesn’t need to actually fall. The market swinging sideways is enough for the leveraged ETF to lose value to erosion. You will profit from that erosion.
Leveraged ETFs are better than futures and options.
Many traders use the leverage in futures and options to magnify their returns. This is not safe.
Futures and options do not allow traders to hold their positions until they are right. The market might move against your position in the short term. You can hold your leveraged ETF until the market reverses in your favor. You can’t do that with futures and options.
- Futures traders always face the prospect of margin calls if they don’t set aside enough cash. And it’s not possible to always calculate the precise amount of margin (cash) that you need to set aside. You really can’t predict how much the market will move against your position in the short term. You can’t always calculate the worst-case scenario correctly. All it takes is one big margin call to wipe out your account.
- Options have an expiry date. If the trade doesn’t work out before that expiry date, you will lose everything you paid for the options. You can’t hold your position until the market reverses in your favor.