What Are 3x Leveraged ETFs — and Should You Invest in Them?

Photo Courtesy: AsiaVision/iStock

Interested in a unique type of investment? 3x leveraged ETFs are stock market investment tools that attempt to offer three times the gains of a traditional exchange-traded fund (ETF). While 3x leveraged ETFs can be a profitable asset, they’re also somewhat risky — just as you stand to make three times the gains, you may also end up weathering three times the losses.

If you’ve heard of these types of ETFs and are curious about how they could become part of your portfolio, join us for a broad overview of 3x leveraged ETFs. You’ll discover what they are, how they work, and some important pros and cons you should be aware of before you make the decision to invest.

What Are 3x Leveraged ETFs, and How Do They Work?

Before you look into 3x leveraged ETFs, it’s important to know how a regular ETF works. ETFs are funds that track the value of a specific set of stocks, usually those in a certain index or within a particular sector.

For example, imagine that you felt very optimistic about the stocks in the S&P 500 and believed they’d continue to rise in value. Rather than purchase every stock in the index separately, you might invest in an ETF like SPY. SPY is designed to track the collective movement of all the stocks in the S&P 500 and fluctuate in price along with their overall value.

While each share of SPY is designed to rise in value at the same rate as the S&P 500, 3x leveraged ETFs take things a step further. If you were bullish on the S&P 500, you might choose to invest in a 3x leveraged ETF like SPXL, which also rises and falls based on the index’s price.

The difference is that SPXL is designed to reflect three times the price movement of the S&P 500. In other words, for every $1 the S&P 500 goes up, you earn $3. The downside, of course, is that for every $1 it goes down, you also lose $3.

Why 3x Leveraged ETFs Are Short-Term Investments

While 3x leveraged ETFs may initially sound appealing, there’s more to them than initially meets the eye. One of the most important things to remember is that they’re designed to be short-term investments. You shouldn’t hold them for longer than a day.

This is because of decay, a.k.a. “beta slippage” or “volatility decay.” One of the reasons 3x leveraged ETFs can offer triple the return is that they have to rebalance at the end of each day. This involves a great deal of complicated math and other calculations.

Photo Courtesy: Hiraman/iStock

But, the main idea is that each leveraged ETF must constantly reassess the total amount of money in the fund and compare it to the price of the underlying assets that the fund tracks. Depending on daily losses or gains, the fund increases or reduces its exposure, usually through derivatives such as futures, options and equity swaps.

Put more simply, a leveraged 3x ETF doesn’t rely on the same math as a traditional ETF. When a leveraged fund experiences a loss, it can take much longer to recover the losses than a traditional ETF.

Are 3x Leveraged ETFs the Right Investment for You?

It’s worth noting that 3x leveraged ETFs are a unique trading vehicle, and typically they’re better suited for more experienced investors. Like any other trading instrument, they come with advantages and disadvantages.

Many of the cons come down to the fact that it’s possible to lose a great deal of money quickly with this type of ETF. That’s why it’s essential to limit your losses with a stop-loss order, which is an instrument that automatically sells your shares if the price drops below a certain amount. The fees for leveraged ETFs also tend to be higher than traditional ETFs, which can eat into your profits faster.

Despite the high-risk nature of leveraged ETFs, they do have perks to consider. Not only do they offer access to options, futures and other assets you might not get exposure to otherwise, but they’re also an excellent way to bet against certain indexes.

While there are specific margin requirements to short sell stocks, it’s sometimes easier to invest in an inverse ETF, which moves in the opposite direction as the asset it’s tracking. Say, for example, that you’re pretty sure the NASDAQ is in for a rough day. You might invest in a NASDAQ 3x inverse ETF like SQQQ. For every dollar the NASDAQ drops, you’ll earn $3.

How to Invest in 3X Leveraged ETFs

Photo Courtesy: Eva-Katalin/iStock

If you’ve decided to give leveraged ETFs a shot, rest assured that buying and selling them is relatively straightforward. You’ll first want to do plenty of research about the different types of leveraged ETFs available and the sectors they track.

At this point, it’s also a good idea to create two separate leveraged ETF watchlists in your brokerage account — one for bullish funds and the other for bearish ones. Simply watching the movements of the leveraged ETFs on each list for a few days can give you a good idea of the sectors that are trending so you can zero in on the ones that look promising.

Once you decide on one or more to invest in, make sure your account is funded and place a buy order just as you would any other stock or ETF. As mentioned above, it’s always a good idea to set a stop-loss order as soon as your buy order goes through to protect yourself against excessive losses.

Otherwise, the selling process works the same as it does with standard stocks and ETFs. All that’s left is to keep an eye on your investment and wait for the right time to cash out. Remember that the 3x leveraged ETF was designed for day trading or very short swing trades, so it’s wise to modify your strategy accordingly.