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.

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.

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.

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.