Caution: How to Approach Leveraged ETFs and Forex

Caution: How to Approach Leveraged ETFs and Forex

| Rich B. Clifford | Blog

Leveraged ETFs and Forex? Most traders are smart enough to know that leverage isn’t just free money, and it certainly doesn’t guarantee results. Simply put, leverage is nothing more than borrowed money. It can make a great idea seem brilliant and a bad idea into a career ender. But using leverage to your advantage means understanding it and how it affects your emotions. Here are two critical ways that leverage can work for you – or against you.

Trading Forex with Leverage

While Forex brokers will often allow you to trade with up to 1:100 leverage, it’s doubtful – and borderline suicidal – for your portfolio. The reason being that losses have a way of outpacing gains very quickly. Repeatedly reaching for maximum leverage is liable to erase any gains you happen to make while trading forex.

Common sense makes it seem like a 10% gain is “equal to” or “cancels out” a 10% loss. But it actually takes a larger percentage of profit to get back in the black after a loss. Leverage makes it 10x harder, or even more, as you’ll see below.

When you use large leverage and lose on a trade, your available funds to put up for collateral decrease and your risk of stopping out increases. Your broker will typically recover their collateral by closing positions, which will only make it harder for you to return to profitability. You won’t have as many assets to work it, so you’ll be hoping for even larger gains.

This story happens all the time. It’s closely related to Gambler’s Amnesia – which we’ve blogged about before – and has a way of sneaking up when we least expect it.

For a simple illustration: say you have $100 in your account and have chosen to trade at an absolute white-knuckle leverage ratio of 1:100. For every $1 of your account balance you trade, you’re also trading $99 of borrowed money, so you’re able to make trades as if you control $10,000.

Say you invest just a small 10% of your total available capital – $1,000 – in a currency pair. If that currency pair experiences a rare, but not impossible, 10% dip, then you would be down $100, i.e. your entire account balance. Poof. It’s gone. You have no collateral left to even get more leverage to try again. That’s how easily things can go wrong with leverage. You run the risk of losing all your capital – or even more – without even trading all your capital.

Leveraged ETFs

Trading leveraged ETFs is common for traders who want someone else to do some of the work of stock picking for them.

Leveraged ETFs often mirror an index fund or other portfolio of stocks. A leveraged ETF will often claim to maintain a 2X or 3X exposure to a given fund or asset class, with the unspoken goal of the fund to have the underlying assets appreciate enough that they pay off the cost of the capital. So, pretty much the same business model as everything else under the sun these days.

A disadvantage of leveraged ETFs is that the portfolio is continually rebalanced, which comes with added costs. Experienced investors who are comfortable managing their portfolios are better served by controlling their index exposure and leverage ratio directly, rather than through leveraged ETFs.

Just like the example above, leveraged ETFs can also lead to losses that outpace gains. For example: $SPY is one of the most popular ETFs on the market, with daily volume routinely in the tens of millions. $SPUU is a 2X leveraged ETF that tracks the same underlying portfolio of stocks as $SPY, but aims to (in the fund listing’s own words)seek a return that is 200% the return of its benchmark index for a single day. The fund should not be expected to provide two times the return of the benchmark’s cumulative return for periods greater than a day.”

Let’s say $SPY is sitting at $100. If $SPY dips 1% then gains 1% on consecutive days, it will end up at:

$100 x (.99) x (1.01) = $99.99

Meanwhile, the 2X leveraged $SPUU will end up at:

$100 x (.98) x (1.02) = $99.96

Sure, it’s only .03% less after two days, but soon enough, those differences add up to big, predictable losses that any medium-to-long-term trader should have the wherewithal to avoid. Hence the caveat pulled straight from the fund’s own website. “The fund should not be expected to provide two times the return of the benchmark’s cumulative return for periods greater than a day.”

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