Leveraged ETFs + Options: The Double-Compounding Risk Most Traders Miss

Fact checked by Vikki Velasquez

Key Takeaways

• Leveraged ETFs seek to amplify the return on the fund’s underlying index on a daily basis.

• Leveraged ETFs are not well-suited for long-term strategies.

• Trading options on a leveraged ETF can further magnify the return, but also brings added risks.

• It is vital to understand how the leveraged ETF functions, as well as the normal drawbacks of derivatives trading.

• Combining the two is best suited for sophisticated traders looking to make tactical, short-term bets.

Leveraged exchange-traded funds (ETFs) use an advanced strategy that seeks to multiply the daily performance of the ETF’s underlying index or benchmark. The funds are high-risk, high-reward vehicles that are suitable only for investors well aware of their pros and cons. 

Options traders may see leveraged ETFs as a way to further amplify returns, but combining leveraged funds with options can create multiple layers of leverage that end up behaving differently than many traders expect.

How Leveraged ETFs Work

Leveraged ETFs provide short-term, tactical traders a way to magnify returns, generally by using swaps or other derivatives. They are designed to deliver leveraged returns over a single day of trading. A 3x fund tracking the Nasdaq 100 would aim to rise 3% if the index popped 1% on any given day.

In order to make this possible, the fund rebalances its exposure every day, typically near market close to ensure that the next day begins at or near the target multiple of the new NAV. If the underlying rises, the fund must increase its exposure to reset; if the underlying falls, it must decrease its exposure.

Due to this daily reset, leveraged ETFs experience a phenomenon known as “compounding,” which skews returns based on the volatility of the underlying price trend. In some cases, compounding may lead to better-than-expected returns; depending on the path of returns, it can also erode returns that investors receive.

This is because leveraged ETFs are “path dependent,” meaning that the volatility of the tracked index can also impact the returns, with bigger swings leading to greater divergence. In other words, the return over a longer time period than one day depends not only on where the index ends up, but also on how it gets there.

Note

If the underlying’s returns are in a steady uptrend, compounding may boost returns above the target leverage multiple; however, in a volatile or sideways market, compounding tends to erode returns over time.

Adding Options Adds Leverage

Options trading already generates leverage, so using options on a leveraged ETF will further amplify exposure. Because the ETF itself is designed to magnify the daily return of its underlying index, options on leveraged ETFs can amplify exposure even further. A 1% move in the underlying index will generate approximately a 3% move for a 3x leveraged ETF, for instance.

Gamma, a measure of how delta changes with price movements, shows that leveraged funds must adjust their exposure daily to keep their leverage on track. The result is that leveraged ETFs must buy at the end of up days and sell at the end of down days, trading in the direction of the market’s movement and reinforcing it.

Time decay in options can also impact positions when it comes to leveraged ETFs, meaning that even if an ETF moves in the direction an investor seeks, the option can lose money. With options on leveraged ETFs, investors are using derivative-on-derivative strategies that depend on more than just the ETF’s direction.

An Overlooked Risk

Volatility drag is an overlooked issue with leveraged ETFs for traders who use them for longer than one day. Over longer periods, volatility in the underlying may erode the leveraged fund’s performance.

Consider an underlying asset that begins at $100, rises by 20% to $120 in one day, then falls back to its original price on the subsequent day (a decline of 16.67%), ending back at $100. A 2x leveraged ETF begins at $100, rises by 40% to $140, then declines by 33.34% on the subsequent day, ending at $93.32. Sharp market swings like this can produce unexpected outcomes even when traders correctly predict the market’s longer-term direction. 

This unpredictability makes options trading with leveraged ETFs even riskier. Add concerns surrounding liquidity and widening spreads during volatile markets, and execution becomes even trickier.

Note

Volatility decay also impacts inverse funds, eroding returns over time.

When To Use Leveraged ETFs

Sophisticated investors may use leveraged ETFs with options for short-term tactical positioning or hedging. For example, if an investor expects a major move in an underlying asset—following an earnings report, say—options on a leveraged ETF offer significant exposure with minimal capital. In some situations, this can limit the maximum loss if the trade goes wrong.

On a similar timeframe, investors looking to capitalize on a short-term directional trend in a given industry while managing broader market risk can pair long and short call trades in leveraged and inverse funds with the same underlying. Options can manage risk thresholds, while the use of leveraged funds amplifies short-term trends.

These strategies typically require very active monitoring and disciplined risk management. They do not use longer timeframes that are common in some options trades.

For most investors, however, it is sufficiently risky to explore either options or leveraged ETF strategies, rather than combining the two. This is especially true for investors seeking to buy and hold positions for more than a single day.

Know Before You Buy

Before making an options trade utilizing leveraged ETFs, thoroughly evaluate the holding period, expected volatility, liquidity, options chain depth, and exit strategy. Any of these factors may make a leveraged fund a poor choice for an options strategy, depending on the investor’s goals and risk tolerance. 

Further, it’s crucial to understand the leveraged ETF’s structure and the contours of the options contract before trading. Limit orders and a close eye on execution costs during volatile markets can help to control risk and minimize potential losses.

The Bottom Line

Leveraged ETFs are highly risky trades that aim to magnify the returns of their underlying asset or index, but only on a short-term basis. Because of daily resets, these funds will skew from their stated performance goals over longer periods. 

Adding options trading to leveraged funds creates multiple layers of leverage, which can further increase unpredictability for investors. Options trades on leveraged ETFs are typically only suitable for sophisticated investors with very specific goals over a limited timeframe.

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