Exchange-traded funds (ETFs) are popular investment tools that track indices, sectors, and other assets. Leveraged and Inverse ETFs are a special category that aims to boost returns, but they come with higher risks.
These funds can offer big rewards but also carry significant dangers. Let’s understand it’s important to understand how they work before investing.
What are Leveraged ETFs?
Leveraged Exchange Traded Funds (ETFs) implement actively managed strategies that employ financial derivatives alongside debt to magnify the returns of their monitored benchmark.
These ETFs aim to achieve twice the daily movement of their base index by borrowing money to purchase additional assets. Due to the use of leverage, these ETFs can experience significant price swings, leading to higher potential gains or losses.
How Do Leveraged ETFs Work?
Leveraged ETFs boost daily returns by 2x or 3x, so if the index goes up 1%, a 2x ETF would jump 2%. But keep in mind that losses are bigger, too. They use things like swaps and futures to make that happen.
Inverse ETFs make money when the market drops—they go up as the index falls. Traders often use them to hedge without short-selling. Like leveraged ETFs, they’re meant for short-term moves, not long-term holds.
Pros and cons of Leveraged ETFs
| Pros of Leveraged ETFs | Cons of Leveraged ETFs |
| Aimed at multiplying returns, making them appealing for short-term profit. | Big profits can accompany steep losses if the market moves against you. |
| Provides access to strategies (like options or futures) without needing deep knowledge or capital. | Daily rebalancing can cause performance to diverge, leading to volatility decay, especially in fluctuating markets. |
| Ideal for traders looking to capitalise on short-term trends and market movements. | Not suitable for long-term investing due to potential volatility and daily tracking. |
What is an Inverse ETF?
Inverse ETFs employ financial instruments that leverage futures and options to provide earnings from benchmark declines. When an index drops 1%, the inverse ETF should rise by 1% of its value. The funds enable traders to obtain market downturn benefits even if they cannot utilise short-selling techniques.
Inverse ETFs function best for brief investment durations, although investors should track them regularly since their actual performance deviates from projected inverse daily results.
How Do Inverse ETFs work?
An inverse ETF combines options contracts and swaps to generate investments that correspond negatively with specific indices.
An inverse ETF that tracks Nifty 50 generates an opposite return pattern to the index movements because the index declines by 1% on a day the ETF rises by 1%.
These funds aim to produce inverse daily returns, but their effectiveness shortens when investors hold them for more than one day because of compounding effects.
Pros of Inverse ETFIs
| Pros of Inverse ETFs | Cons of Inverse ETFs |
| Investments gained from falling stock markets help protect against stock market declines. | Significant losses can occur when market movements go against your prediction. |
| Unlike short selling, borrowed shares are unnecessary; you can buy the ETF for a bearish strategy. | These ETFs are not ideal for long-term investing but work well for short-term price movements. |
| ETFs have an exchange-like status, allowing them to be traded like stocks and other funds. | ETF performance can be unpredictable in volatile conditions, making it hard to anticipate accurately. |
Ideal Users for Leveraged and Inverse ETFs
Here’s a quick look at who might find leveraged and inverse ETFs useful and what kind of investor they’re best for:
| Experienced Traders and Investors | Leveraged and inverse ETFs are complex products that involve financial derivatives. These are best suited for individuals who fully understand the risks and mechanisms involved. |
| Short-Term Traders | Day traders and swing traders who seek to capitalise on short-term price movements or trends in the market. They need to monitor the market closely and react quickly. |
| Hedgers | Investors who use these ETFs to hedge their portfolios against market downturns, protect other investments or profit from market declines (inverse ETFs). |
| Market Timers | Traders with strong predictions about short-term market movements or specific events. They use leveraged ETFs to amplify gains during expected market fluctuations. |
| Those Seeking Access to Specialized Strategies | Investors are looking for exposure to complex strategies like options and futures without needing deep expertise or large capital. |
Use Leveraged and Inverse ETFs Strategically for Short-Term Gains
Combining leveraged and inverse ETFs offers traders valuable investment possibilities to maximise short-term gains and short-market movements. Long-term investment using these products is not advised because their daily systematic rebalancing procedures bring elevated market volatility risks. You should understand all the workings of these products before using them due to their risk of significant market losses.
