Mastering Leveraged ETFs

Discover how leveraged ETFs work and why they have become popular tools for active traders seeking amplified market exposure. In this IBKR Podcast episode, Jeff Praissman and Will Rhind break down daily resets, compounding effects, earnings-season trading, volatility and practical ways investors use leveraged ETFs in today’s markets.

Summary – IBKR Podcasts Ep. 393

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman

Hi, everyone. This is Jeff Praissman from Interactive Brokers. It’s my pleasure to welcome back to the Interactive Brokers Podcast Studio, Will Rhines from GraniteShares. Hey, Will. How are you? 

Will Rhind

Good, thanks, Jeff. 

Jeff Praissman

Love having you come in for our monthly talk on all things about the market, whether it’s commodities or ETFs or options or futures. And today we’re gonna talk about leveraged ETFs, which is a pretty interesting instrument, right? So, Will, it’s probably best to start with the foundation. 

How do… ’cause I think a lot of people may have heard of leveraged ETFs, but they’re not sure really what they are or how they work. So how do they achieve their daily return targets? And why is that daily reset so important? 

Will Rhind

Yeah, so leveraged ETFs in a nutshell are ETFs where you have prepackaged leverage or preset leverage on anything from an index to a single stock. And these are super popular here in the United States. Typically, that’s two times the leverage factor, so two times the return of an underlying stock or an underlying index over a given day, and those can be both long and short. 

Jeff Praissman

And how should traders think about these leveraged ETFs? Like, should they think about them differently than traditional ETFs in terms of structure, in terms of risk, in terms of time horizon? 

Will Rhind

Yeah. So there’s a few things that people should be aware of. I think the most important thing, Jeff, is that leveraged ETFs work in the same way really regardless of whether you buy a leveraged ETF from a company like us or from other folks in the market. They’re based upon a daily rebalancing or a daily reset mechanism. 

What that means is the portfolio gets rebalanced at the end of each day, and the reason for doing that is so the leverage remains constant. In other words, if it’s two times leverage, you want to make sure that it’s two times leverage today, it’s two times leverage tomorrow, or in six months’ time, et cetera. Now, the net effect of doing that is you do get some deviation from the underlying price over time. So in other words, let’s just hypothetically say that you were to look at the price of a leveraged ETF over a 12-month period versus the price of the underlying, and it wouldn’t be exactly two times. And the reason for that is because the portfolio has been or is being rebalanced on a daily basis. 

Jeff Praissman

And, well, compounding’s often misunderstood. So how does it, kind of diving a little bit more into this, how does the timing of these rebalances impact returns over multiple days, especially if the markets are choppy? 

Will Rhind

Yeah. So at the risk of oversimplifying it, what the effect amounts to is in a trending market, the leveraged ETF will most likely outperform the 2X return if you’d held the stock itself or the underlying index. In a down market, it will most likely underperform the 2X, and then in a choppy market, it will most likely underperform, again, the two times metric on the underlying stock because the portfolio is constantly going up and down. So trending markets are really the environment that these products love most. 

Jeff Praissman

Gotcha. And obviously we’re not giving any kind of trading advice out here, but who are these leveraged ETFs designed for? Like, who are these leveraged ETFs designed for? Are they for short-term traders, tactical allocators, or someone in between? 

Will Rhind

Yeah, I mean, I think from a first principles perspective, if you think about what these products do and the appeal of it, it just simply provides access to leverage in an ETF, and you don’t have to worry about margin or traditional margin accounts. So you think of a world where traditionally you’d have a brokerage account, you’d have to get margin, and from a leverage perspective, if it went against you, you might end up owing the broker money or being closed out of your position prematurely. So ETFs solve that. You don’t have any margin requirements. And so from that perspective, it’s then just for anybody that wants to implement or amplify exposure to underlying stocks or indexes. And people use them in all sorts of different ways. So clearly at the moment, obviously we’re just finishing up the earnings season, which is probably one of our busiest times during the year. 

And you can imagine that you see elevated trading patterns when all these stocks are reporting earnings, and obviously particularly ones where we have leveraged ETFs in the mix. And so that’s a super popular time of year. And we can regularly see on our platform trading volumes of above $4 billion a day in earnings season. 

Now, I think one of the attractive things for traders beyond the fact that you don’t have margin is that with ETFs, they allow you to participate in the pre-market and the post-market, which is different from options, for example, where you can’t do that. And so we see a lot of action particularly from international investors who are able to trade through overnight platforms and overnight markets to domestic investors here that are able to place orders in the pre- and post-market. And that’s a very interesting sort of phenomenon we observe, particularly again around earnings times and when there’s volatility in the market. 

Jeff Praissman

Yeah, I mean, I’m glad you brought up earnings ’cause earnings season’s always a big time of year, four times a year really. Volatility tends to spike, and then it tends to collapse, and you have this leading up to this news, and then all of a sudden the news comes out. So could you dive a little bit more into how that environment impacts these leveraged ETFs’ performance and behavior? 

Will Rhind

Yeah, I mean, I think what people really look for is big moves. And clearly if you can earn two times the performance of an underlying over a given day, then you’re probably more naturally drawn to markets that are volatile and where there’s a lot of movement, both on the long and the short side, I should say. 

So this is not just about the potential for a stock or an underlying to go up. This is about being able to take advantage of a downward movement, which is also very important in volatile periods. But I think typically what people are looking to do is express a bullish or bearish view over a short period of time around, let’s say, an earnings announcement or a big piece of market- or market-moving news coming out of the government or the Federal Reserve or something like that. 

Jeff Praissman

Gotcha. So really kind of going back to your original thing where if you have a strong directional conviction, this may be something that you want to look into. I want to kind of flip the script a little bit here, Will, and what are some of the bigger, I guess I don’t want to say biggest risks, but what are some of the risks that traders may overlook when using these leveraged ETFs? 

Will Rhind

Yeah, I mean, I think, well, first and foremost, the most obvious with any kind of leverage is yes, you have the potential for two times the return or double the return of the underlying, but you also have potential for two times the losses of the underlying as well if it goes in the wrong direction. So just, I guess as a first principle, anytime you’re using leverage, then there’s more risk involved and therefore there’s more risk of losses, not just gains. And then I think beyond that, it’s really understanding the daily rebalancing, the path dependency of the ETF over time, particularly how the longer you hold the ETF, the more that return stream will potentially deviate from the two times linear return of whatever the underlying is, be it a stock or an index. 

But I think if you understand those two principles, then a lot of the other mechanics are really just regular ETF risks, if you want to call them that, such as trading, best times to trade a particular underlying if it’s thinly traded, if it trades a lot, timing considerations again, where it might be more volatile over earnings. And that may be a time you actually don’t want to participate, or maybe it’s a time you do wanna participate. But those are more market timing things as opposed to actually structurally with the product. 

Jeff Praissman

And Will, I’m gonna skip question eight. It’s probably talking about timing and trading, which is probably not a good idea. We don’t think we need to go there. Will, can these instruments be used for risk management? Is that something that individuals may want to utilize these for? Maybe short-term news events coming up and they have a position and they can kind of buy one of these leveraged ETFs that would kind of, you know, especially in these short-term, potentially high-volatility windows? 

Will Rhind

And that’s right. So when you’re looking at these kind of instruments, I think sometimes it’s left unsaid that you can use these defensively as well as offensively. And so if you have a short exposure on an underlying stock, you can do obviously anything from just providing pure hedging activity against the performance of the underlying to tax strategies where you’re able to manufacture taxable losses against the portfolio, or just be a bit more tactical because you probably are long the underlying stock or long the underlying index via an ETF itself, and maybe you don’t want to sell that and realize a taxable event. And so maybe using either a short position or long position around that to trade specific events is something that’s appealing to you. 

Jeff Praissman

And, well, this has been great. I kind of want to end it though with a, for people considering these leveraged ETFs, I guess what would be the kind of the most important rule of thumb or best practice for them? 

Will Rhind

Well, I think the starting point would be for anybody thinking about these clearly more risky products than regular ETFs, in other words, unleveraged ETFs. So I think the starting point would be to assess whether leveraged ETFs are a good fit for you. And so if you’re somebody that is comfortable with the risk and you’re comfortable with how these products work, then they can be something that is an addition to your portfolio, to your trading activities, to your investing style. 

And clearly the amount of interest that we have in these products is absolutely huge, and therefore there’s a community of users out there that absolutely love these products. But like other investing-related activities that are more on the risk curve, such as prediction markets or cryptocurrencies, nothing is risk-free in this life. And definitely leveraged ETFs are firmly in the category of those that love, or like, adding more risk to the portfolio and sort of thrive in these kind of volatile environments. 

Jeff Praissman

Will, this has been great as always. For our listeners, you can find more from Will Rhind at graniteshares.com or on our website at interactivebrokers.com. Click on Education, find great podcasts, webinars, and articles. Thanks again, Will, and looking forward to next time. 

Will Rhind

Thanks, Jeff. Appreciate having you back on. Thank you. 

Jeff Praissman

Yep.