Jasmine Birtles
Your money-making expert. Financial journalist, TV and radio personality.
How Leveraged and Inverse ETFs Work and Why They’re Not for Everyone!
Ruby Layram
18th Mar 2025
Exchange-traded funds (or, ETFs) have risen in popularity over the last few years, offering a simple way to gain exposure to different markets. But if you’ve been diving deeper into the ETF world, you may have come across leveraged ETFs and inverse ETFs.
These sound exciting—multiplying your gains or profiting when the market drops? Yes, please! But hold on. These funds come with serious risks, and they are definitely not for everyone.
So, before you jump in, let’s break down what leveraged and inverse ETFs are, how they work, their benefits, their dangers, and how to decide if they’re right for you.
What Are Leveraged ETFs?
A leveraged ETF is a type of exchange-traded fund that aims to magnify the daily returns of an underlying index.
Instead of tracking the market 1:1, it might aim for 2x or even 3x the daily performance of an index like the FTSE 100.
That means if the FTSE 100 rises 1% in a day, a 2x leveraged ETF would ideally go up 2%, and a 3x ETF would go up 3%.
How Do Leveraged ETFs Work?
Leveraged ETFs use a mix of derivatives, futures contracts, and debt to increase their returns. This is what allows them to generate twice or three times the gains (or losses) of their benchmark index.
Leveraged ETF Example
Let’s say you invest in ProShares Ultra S&P 500 (SSO), a 2x leveraged ETF that tracks the S&P 500 ( a major US index). If the S&P 500 goes up 1% in a day, your ETF should go up roughly 2%. But, if the market drops 1%, your ETF loses 2%.
Now imagine a 3x leveraged ETF like Direxion Daily S&P 500 Bull 3X Shares (SPXL). That same 1% market increase would give you 3% returns, but a 1% market drop would result in a 3% loss.
Sounds great when the market is going up, right? But what if things turn south? That’s where the risks come in.
What Are Inverse ETFs?
An inverse ETF does the opposite of a normal ETF—it’s designed to go up when the market goes down.
It’s like short-selling an index but without the need to borrow stocks or use a margin account.
How Do Inverse ETFs Work?
Inverse ETFs use derivatives like futures contracts and swaps to achieve the opposite return of an index. If the market drops 1%, an inverse ETF should rise 1%. If the market goes up 1%, the inverse ETF loses 1%.
Inverse ETF Example
One of the most well-known inverse ETFs is ProShares Short S&P 500 (SH). This ETF is designed to move in the opposite direction of the S&P 500. If the S&P 500 falls 2%, SH should rise 2%.
There are also leveraged inverse ETFs, such as the ProShares UltraShort S&P 500 (SDS), which moves twice the opposite of the S&P 500. So, if the index drops 2%, SDS should increase 4%. But if the market rises 2%, you’re looking at a 4% loss.
The Benefits of Leveraged and Inverse ETFs
At first glance, these ETFs might seem exciting. Here’s why some traders love them:
Potential for high returns: If you time the market correctly, leveraged ETFs can amplify your gains, making them a favourite for short-term traders.
Hedging tool: Inverse ETFs allow investors to protect their portfolios during market downturns without needing to short-sell stocks or buy options.
Easy to trade: Unlike options or futures, which require special accounts, leveraged and inverse ETFs trade just like regular stocks.
No margin required: You don’t need a margin account to trade leveraged or inverse ETFs, unlike traditional short-selling.
The Risks and Drawbacks of These ETFs
Although these ETFs might seem exciting, it goes without saying that they come with significant risk!
Time decay: These ETFs are designed for daily returns, not long-term investing. Over time, due to compounding and volatility, they may not track their targets accurately.
Massive loss potential: Just as they amplify gains, they amplify losses. If the market moves against you, your losses can stack up fast.
High fees: Because of the use of derivatives, leveraged and inverse ETFs carry higher expense ratios than normal ETFs. Over time, these fees can eat into profits.
Should You Invest in Leveraged or Inverse ETFs?
Leveraged and inverse ETFs are not for everyone. If you’re considering them, ask yourself:
Are you a short-term trader? These ETFs are best for day traders and swing traders, not long-term investors.
Can you stomach the volatility? A few bad days can wipe out a significant portion of your investment.
Do you understand the risks? Make sure you grasp how daily rebalancing affects performance over time.
Are you using it for hedging? If you’re using inverse ETFs to protect your portfolio, they can be a useful tool—but not a buy-and-hold strategy.
Actionable Tips for Trading Leveraged and Inverse ETFs
If you fancy taking a bit of a risk, here are some top tips for investing in leveraged or inverse ETFs.
- Use a stop-loss order: Protect yourself from excessive losses by setting stop-loss limits.
- Monitor daily performance: These are not ‘set it and forget it’ investments. Keep a close eye on market movements.
- Limit your exposure: Don’t bet the farm. Allocate only a small percentage of your portfolio to these ETFs.
- Understand fees: Check the ETF’s expense ratio before investing to ensure the costs don’t eat up your profits.
- Avoid holding long-term: These are meant for short-term trades, not buy-and-hold strategies.
Leveraged and inverse ETFs can be powerful tools, but they are not for beginner investors or those with a long-term mindset. They can supercharge gains, but they can just as easily wipe out your investment. If you’re considering them, make sure you understand how they work, their risks, and the strategies to use them effectively.
So, before you dive into leveraged or inverse ETFs, ask yourself: Are you able to handle risk?
Are you interested in learning more about investing? Why not sign up to the MoneyMagpie bi-weekly Investing Newsletter? It’s free and you can unsubscribe at any time if you find it isn’t for you.
Disclaimer: MoneyMagpie is not a licensed financial advisor and therefore information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence. When investing your capital is at risk.
Leave a Reply