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Duration: 4:14

Contributor: WisdomTree Europe

Level: Beginner

This lesson explores short and leveraged (S&L) ETPs and what investors should be aware of when investing in these products – for example, daily returns and compounding.

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Study Notes:

Investing in Short & Leveraged ETPs

Exchange traded products (ETPs) were initially seen as a way of gaining passive long exposure to key equity benchmarks, but these products now offer exposure to increasingly exotic and diverse underlyings.

Short and leveraged (S&L) ETPs are particularly popular. That’s because in the absence of ETPs, acquiring short and leveraged exposure can be complicated and difficult to access. It may involve direct borrowing, margin management and option trading.

S&L ETPs helped simplify these complexities.

They provide short, leveraged short, and leveraged long exposure to underlying benchmarks, but retain the accessibility and tradability of ordinary shares. Also, the indices underpinning S&L ETPs have transparent, publicly available pricing methodologies.

How S&L ETPs Work

In contrast to long ETPs, short ETPs rise in value when an underlying benchmark declines, so they can be used to profit from, or protect against, downward price movements.

Leveraged ETPs magnify exposure to an underlying index and can be applied to both long and short positions.

They enable investors to gain a greater degree of exposure with less upfront capital, allowing them to express high conviction investment views or to implement capital efficient hedging strategies.

Leverage Factor

The exposure of S&L ETPs to an underlying benchmark’s performance is multiplied by a given multiple known as its ‘leverage factor’.

The time period that is defined, usually daily, is very important, because the leverage factor is applied to the benchmark performance over this period and then reset.

For example:

An investor invests in a 3-times (3x) leveraged short ETP for three days.

Day 1)
On day one, if the index falls 2% over the day to 98, then with a short leverage factor of 3, the value of the ETP will increase to 106, i.e. a 6% rise.

Because each new period requires the ETP’s performance to be based off a new base, in this example, a daily one, S&L ETPs can see their returns subject to a compounding effect.

Day 2)

So, if on the following day the index falls a further four points, which represents a 4.1% decrease from its previous value, then the value of the ETP will increase by 13 to a new value of 119, i.e. a rise of 12.3% from its previous value.

Day 3)

If, however, on the third day the underlying index goes up by 2.1% to 96, then the ETP investor will incur a loss of 6.3% for that specific period, and the ETP value will decrease from 119 to 111.4.

So, overall, by the end of day three, the value of the ETP is increased by 11.4%, even though the index has declined by 4%. Hence, the three-day performance of the index should not simply be multiplied by -3 as a means of estimating the 3x leveraged short ETP return.

Volatility

Due to the potential for market volatility, S&L ETPs should be actively monitored.

Generally, if volatility is low, and the market is trending in favor of the investor, then compounding will increase the price of the S&L ETP. Conversely, a volatile market with daily gains and losses, will generally result in the S&L ETP underperforming.

In summary, S&L ETPs offer a suite of investment strategies that span all asset classes, allowing investors to express tactical views and hedge risks while preserving capital.

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Disclosure: Wisdom Tree

WisdomTree is not affiliated with Interactive Brokers LLC

Disclosure: Interactive Brokers

Information posted on IBKR Traders’ Academy that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Academy are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from Wisdom Tree and is being posted with permission from Wisdom Tree. The views expressed in this material are solely those of the author and/or Wisdom Tree and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

Disclosure: Forex

There is a substantial risk of loss in foreign exchange trading. The settlement date of foreign exchange trades can vary due to time zone differences and bank holidays. When trading across foreign exchange markets, this may necessitate borrowing funds to settle foreign exchange trades. The interest rate on borrowed funds must be considered when computing the cost of trades across multiple markets.

Disclosure: Leverage ETFs

Complex or Leveraged Exchange-Traded Products are complicated instruments that should only be used by sophisticated investors who fully understand the terms, investment strategy, and risks associated with the products.  Learn more about the risks here: https://gdcdyn.interactivebrokers.com/Universal/servlet/Registration_v2.formSampleView?formdb=4155

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