Understanding The Derivatives Used In Leveraged ETFs

Leveraged ETFs offer traders a way to gain exposure to certain market indexes without investing direct capital into their components. Unlike typical ETFs that are primarily composed of stocks, leveraged ETFs offer increased exposure by including derivatives within each fund, which is why these instruments have different risk characteristics than plain vanilla ETFs. This article will break down the financial instruments commonly found in leveraged ETFs and how understanding them can help traders use ETFs to seek profit.

Derivative Basics

At the high level, derivatives are a contract between a buyer and a seller wherein both parties agree to exchange assets in hopes that the asset they acquire gains value over what they gave up for the period of the contract. That contract can itself be traded or exchanged over its lifespan, rising or falling in value depending on the value of the asset it represents and the time until it is fully executed.

The point is that, beyond the asset itself, the contract becomes a thing of value for the potential profit it represents. Similarly, the duration of that contract can represent a means of speculating on relative movements of an asset’s value, either up or down, based on the assets that are exchanged. As such, derivatives can provide a high degree of leverage to an investment because, until execution, investors are only paying the fractional price of owning the contract while potentially benefiting from favorable relative moves in the assets.

When used in conjunction with other securities, a curated selection of derivatives can provide enough leverage to potentially deliver two- or three-times multiples (or inverse multiples) on an initial investment. Hence, leveraged ETFs.

Flavors of Derivatives

Two common types of derivatives used in leveraged ETFs are futures and swaps. Options contracts can also sometimes be classed as derivatives, although they’re used less frequently in leveraged ETFs.

For most people, futures contracts are the most familiar form of derivatives, wherein two parties agree to exchange an asset, usually commodities like gold or oil at its current value at a designated time in the future. The seller does this hoping the asset loses value, while the buyer hopes it rises in value. The difference between the contract and the actual price at the point of the contract’s execution informs the futures contract’s value. That contract itself can be traded or exchanged over its lifespan, rising or falling in value depending on the value of the asset and time until execution.

Swaps, on the other hand, are just what they sound like: asset exchanges, typically of cash flows, between two or more parties. The classic example of a swap is total return swap. This an agreement in which one party makes payments based on a set interest rate, while the other party makes payments based on the return of an underlying asset (say the S&P 500 index) that includes both the income it generates and any capital gains. If that underlying asset’s value falls, the party paying those returns benefits while, if the asset’s value rises, the party paying the fixed rate will benefit.

The underlying principle of these is that, while the asset’s price is referenced by the value of the contracts, the actual worth of the contract is determined relative to a benchmark.

Why Derivatives work in leveraged ETFs

Basically, leveraged ETFs use derivatives to gain exposure to an asset, like a commodity, an index, or a debt asset like loans or bonds, while also maximizing leverage by not purchasing those vehicles directly. This is because, until execution, derivatives traders are only paying the fractional price of owning the contract while still profiting off of moves in the asset. This is called unfunded exposure, and can generate disproportionate profits or losses depending on which side of the contract ends up favorable.

While this type of trading can pose a high degree of risk, leveraged ETFs attempt to mitigate the potential for ruinous losses. This is primarily done through the use of third-party banks to act as additional counterparties, custodians and guarantors of the contract in the event one of the parties cannot meet its obligations. Other measures are more precautionary and involve evaluating counterparty credit risk and implementing hedges against outsized losses.

The Takeaway

It’s important to remember that leveraged ETFs are meant for short-term trades. The derivatives that these funds use are used to magnify returns over a given day. Over time, these derivatives can cause leveraged ETFs to move in unpredictable ways.