Some traders and investors want to use leverage in their portfolio. On the surface, it seems like this is pointless. Leverage magnifies your gains and your losses, so theoretically there should be no difference between you using and not using leverage.
But this isn’t entirely true. If you can protect your downside with stop losses and let your winners run, leverage will allow you to magnify your returns while keeping your losses under control.
There are 3 types of common financial products that have leverage:
- Leveraged ETFs.
Here’s why leveraged ETFs are the best out of these 3 leveraged investment and trading vehicles.
The problem with futures
For those who aren’t aware, a futures contract is the legal agreement (the right and the requirement) to buy or a sell a commodities or underlying market at a predetermined price in the future.
All futures contracts have leverage. When you buy or sell a futures contract, you are essentially putting down a deposit that is a low percentage of the total value of the assets in the futures contract. This is similar to paying for a down-payment on a house. This small deposit means that your position is leveraged – the market’s movements will magnify your portfolio’s returns.
This deposit is called the “initial margin”, which is usually 5-10% of the value of the futures contract. If the initial margin is 10% of the contract, you are essentially leveraged 10-1.
The problem with this is that if the market moves against you, your entire position might be wiped out. For example, if you are long and the market falls 15%, a futures position with 10% margin will be wiped out if you can’t raise the additional cash to meet that “margin call”.
This means that with futures contracts, you cannot hold your position until you are right.
Nobody can always get the timing of a trade or investment perfectly. Sometimes you will be too early, which means that the market will temporarily move against your position.
If the market moves against your position and you face a margin call, your position could be wiped out. It doesn’t matter if your market outlook was ultimately correct and the market rebounded in your favor. In the meantime, you lost everything and you couldn’t hold your position until you were right.
The problem with options
Options give you the right, but not the obligation, to buy a security in the future at a predetermined price. You must pay a “premium” to buy this right (the options contract).
For example, let’s assume stock XYZ is at $100. You buy call options for a $3 premium. If the market rises $10, you just made 233% on your position. Hence you can see how options inherently use leverage. A person who bought stock XYZ outright would have made 10%. The options trader made 233%.
Options have a similar problem to futures contracts – you cannot hold your position until you are right.
Options have an expiry date. This means that if the market doesn’t move in your favor BEFORE a specified date, you will lose everything. And as I’ve already mentioned, nobody can always get their timing right. Sometimes you will be too early with your position. This unfortunately means that if the market’s temporary movement against your position lasts until the options expiry date, your options will expire worthless.
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How leveraged ETFs solve this problem
Leveraged ETFs do not have the problem of “cannot hold your position until you are right”. This is because leveraged ETFs work differently than futures and options.
Leveraged ETFs are tied to an underlying market. For example, UPRO (3x leveraged S&P 500 ETF) is tied to the S&P 500. The only difference is that UPRO magnifies the S&P’s returns by 3x.
Leveraged ETFs multiple the DAILY change in the underlying market. This is different from futures and options, which magnify the underlying market’s returns from the day you open the position to the day you close the position.
Here’s a simple example.
Let’s assume that the underlying market went from $100 to $110 to $121 (essentially 10% increase per day).
A 3x leveraged ETF would increase 30% per day. It would go from $100 to $130 to $169. Meanwhile, owning a futures contract with 3x leverage (33.33% initial margin) would turn $100 to $163.
Notice how there’s a difference between $169 and $163. That’s the “compounding” that comes from leveraged ETFs.
The inverse means that while options and futures contracts can leave you penniless, you can never lose everything with a leveraged ETF. A leveraged ETF will never go to zero, and since there is no expiry date, you can afford to hold until you’re right.
If the market moves against your position in the short term, that’s ok! Just hold your position long enough until the market reverses in your favor. The leveraged ETF will lose money in the interim, but at least you won’t be forced to cut your position at the bottom of the market. You can just wait out your losses until it turns to a profit.
In essence, leveraged ETFs are better at protecting your downside than futures and options.
Thanks for reading! I’m Troy Bombardia, the trader and investor who shares his thoughts on the financial markets at Bull Markets. I primarily focus on the U.S. stock market, where I make medium-long term trades. I don’t focus on short term trading. A better option is to buy and hold, as is the expectation with Motley Fool picks.
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