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What Are Leveraged ETFs?

This article was originally published on ETFTrends.com.

Just like an individual stock, an exchange-traded fund (ETF) can be bought and sold freely via an exchange. This dynamic ability gives traders the option to make quick intraday trades to seek a profit.

Traders can also take advantage of leveraged ETFs in order to capitalize on the short-term momentum of a specific ETF. What is leverage and how can an investor incorporate leveraged ETFs into his or her portfolio?

What is Leverage?

If an investor is betting that a specific sector or stock will go down, he or she will have to short that stock or group of stocks. Furthermore, shorting stocks are typically bought on margin, meaning the investor will have to borrow the money from the broker--known as leverage.

With an inverse ETF, an investor can be bearish without having to buy the securities on margin. If an investor does wish to leverage a trade, there are leveraged ETFs available that allow investors to amplify their returns by multiples of 1.25, 2 or 3 times, depending on the ETF product.

The amount of leverage will depend on how aggressive the trader wants to get. Investors who are new to leveraged ETF trading can opt for lesser leverage to test out the waters.

Leveraged ETF Diversification and Costs

An ETF tracks an index, bonds, commodities, currencies, or a mix of various asset classes. Like stocks are shares or fractional ownership of a company, the ETF owns underlying assets and divides ownership of those assets into shares that can be bought and sold on a major exchange.

Furthermore, as opposed to ownership of a company, ETFs own the actual stocks themselves. As such, ownership of an ETF offers diversification advantages compared to single stocks.

Stocks are exposed to all of the risk associated with ownership of that particular company. Conversely, an ETF that purchases a mix of stocks or other assets will have less risk exposure.

Because an ETF can track an index, it can be passively-managed. This translates to lower costs to investors when compared to mutual funds, which are typically actively-managed.

Actively-managed mutual funds carry greater operating costs because they have to pay analysts and other research specialists. The lower costs of ETFs show in their expense ratio, which is the cost to run the fund.

However, a leveraged ETF will typically carry higher expense ratios equal to 1 percent or higher. However, this could still end up being cheaper if a trader uses other forms of leverage.

Furthermore, since a trader typically uses a leveraged ETF to get in and out of a trade quickly, the benefits of diversification are not usually taken into account compared to a long-term investor.

Amplifying the Returns

The primary purpose a trader will want to use leveraged ETFs is to amplify his or her returns. Leveraged ETFs will typically carry two or three times the returns of the index, depending on the product.

So if an index tied to a 2x leveraged ETF moves 1 percentage point, a leveraged ETF trader will earn 2 percent. If it moves 2 percentage points, the trader will earn 4 percent and so on.

The amplified return is due to a leveraged ETF using futures contracts as its underlying assets. The futures contract is an agreement to purchase or sell assets at a fixed price, but the assets are delivered at a later date.

Firms like Proshares or Direxion offer traders leveraged ETF products with a wide range of leverage and sector exposures. Furthermore, there are leveraged inverse ETF products available if a trader wishes to take a bearish point of view on a certain asset or market.

Examples of Leveraged ETFs :

For more educational information on ETFs, click here for Education Central.