Understanding Leveraged Shares
A day ago, I released the "Leveraged Share Decay" indicator for those who trade or invest in leveraged shares. What the indicator does is it tracks the consistency of returns and the rate of decay of a leveraged share against its benchmark. Leveraged shares tend to be seen as "risky" and grouped into the "option-esque" category of trading. From my experience trading them, I would greatly disagree with that notion, as I find it much easier and more enjoyable to trade leveraged shares than to trade options. However, in this post, I want to outline some of the facts of trading leveraged shares and how they work. So, let's get started!
What is a leveraged share?
A leveraged share or leveraged ETF is an ETF that aims to increase exposure to a specific underlying asset. For example, UPRO aims to return 3 times the amount of the S&P. So, in theory, if the S&P were to return 10%, UPRO should return 30% (3 x 10).
How it does this is by using instruments such as options and futures contracts to leverage the exposure to the underlying asset. Of course, this comes with some risks, such as if the ticker goes against you as well as the costs involved in the management and labor of such a task.
Let's take a deeper look at how leveraged shares work by looking at UPRO:
UPRO is the 3x bull leveraged share of the S&P 500. Compared to SPY, it tracks it very well. The average drift (the amount the share may vary in cost compared to the underlying) is about $1 after 10 days, but peaks at a max of around $3 after 252 (1 trading year) days. This means the decay you can expect to experience holding UPRO for 1 year is about a $3 decay per share.
Let's say you entered a UPRO position on January 9th, 2023. At the time, UPRO was about $34.62. Let's say you bought 100 shares at $34.62, for a total entry cost of $3,462. As of today, you would be up 59.28%, or a net P&L of $1,965. If you had bought SPY, you would be up 21.91%.
So let's do the comparison. UPRO is 3X leverage, so we would expect our returns to be 3 X 21.91%. To do this, we simply convert the percentages into a decimal place by dividing by 100, then add. So here is the math:
21.91% / 100 = 0.2191 59.28% / 100 = 0.5928
Assuming that UPRO is 3X spy, we would need to multiply SPY by 3:
0.2191 x 3 = 0.6573 Now convert that back into a percentage by multiplying it by 100:
0.6573 x 100 = 65.73%
So, our expected return should have been 65.73%. However, owing to the decay, it was around 59.28%, with a loss of around 6.45%. This 6.45% is equal to about a $223.30 loss of our initial investment ($3,462 x 6.45% = $223.30). Considering we bought 100 shares, that would be about $2.23 per share, well within the indicator’s prediction of decay.
Now, it's unfair to view this as a loss or "decay" in some circumstances because you are essentially paying for a firm to manage the exposure of the share to the S&P. So this "cost amount" can actually be viewed as a cost of labor, no different than paying a management firm to manage your portfolio for you.
That said, leveraged shares, as investment mechanisms, are only good as investment mechanisms when the markets are good. Let’s take a look at what would have happened if we would have invested in UPRO on March 14th, 2022, during the 2022 bear market decline:
This would be a total of 457 trading days, or roughly 2 trading years.
At the time, UPRO was $52.06. If we did 100 shares at $5,206, we would just be recovering now, vs. us having bought SPY, we would be up 11.90% now:
So what happened here?
Volatility. And this is why, I think, people draw the comparison between options and leveraged shares, because if the trade goes against you for a prolonged period of time and a very dramatic fall, the share is going to decay like mad. What causes this is often referred to as “Beta Slippage.” It is a compounding effect of daily rebalancing in leveraged exchange-traded funds. This happens because, as indicated before, in order to gain the exposure they do, leveraged shares hold derivatives such as options and futures contracts to increase their exposure to the underlying asset.
To understand Beta Slippage, let’s use a made-up example. We have share X, at a value of $40, which has a 2X leveraged bull share, Y, at a value of $8. You buy 100 shares of Y for a total of $800. The next day, X goes up 10%, and your position goes up 20% (2 x Bull). You now have $160 in profit, for a total value of $960. You don’t sell because you believe it will go up an additional 20%. However, over the coming days, X falls about 9.5%. This would translate to a 19% fall on Y (9.5 x 2). If we do the math:
$960 x 19% = $182.4
960 – $182.4 = $777.6
You now have $777.6, which is less than your initial investment. This is the compounding effect.
What if you just invested in the underlying?
$40 x 20% = $48
$48 x 9.5% = $43.44
So, had you invested in 100 shares of the actual underlying, you would still be up $3.44 per share.
The bright side:
The bright side to this is, beta slippage is much easier to account for, track, and calculate with leveraged shares vs options. The phenomenon happens with both instruments, but it's much more nuanced to calculate with options.
When does Slippage show up?
It can show up as soon as the same day if the decline or rise happens starkly and fast enough, but in general, if you are picking a stable ETF like UPRO, it tends to be noticeable at 30 to 50 days:
In the example above, I picked a period consisting of 30 days where SPY was whipsawing like mad. For the most part, UPRO remained fairly stable until day 30 when you can start to see slippage appear. For example, SPY was able to fill the gap (first blue circle) at $447.71, but UPRO failed to fill its gap. SPY then broke above the immediate resistance at $448.71; however, this same resistance on UPRO was not broken.
If we look at the decay tracker indicator, we can see as time passes, not only does the drift in price variation increase but also the slippage increases:
A mention of inverse leveraged shares
I think it’s important to mention inverse leveraged shares. They are viewed, generally, as riskier than bull leveraged shares, and, to an extent, this is true, but not for the reasons you may be thinking. Inverse leveraged shares are victims of the same mathematical and compounding faults as their bullish counterparts, no more and no less. The main risk associated with inverse leveraged shares is the perma-bull thesis, i.e., stocks only go up. And this thesis has proved pretty factual, especially towards the end of 2023.
That said, I have personally held inverse leveraged shares (specifically, SPXS) for roughly 6 months, from April till September during the 2022 decline when I was targeting 350 on SPY. The end result? Some decay resulted, but I still gained just over 40%. There was a little stint where, despite SPY not going up as high as it did before, my position still went red (see chart below):
But quickly recovered. This actually was a wakeup call to always set a trailing stop and take profits when you’re up! I was too confident there. But besides that point, you can see that it did work out holding it a bit longer term.
That said, if we look at SPY vs SPXS using the decay tracker, here are the results:
We can see that there is substantially more slippage on SPXS vs UPRO. Why? Because of the compounding factor. SPY has been in a massive uptrend since October, constantly pushing up and up. This compounds the losses on an inverse leveraged share and increases the slippage with the wild up moves followed by very little pullback. And that is the danger of inverse leveraged shares because you are fighting against a predominant market mantra, ONLY UP, NEVER DOWN.
Alternatives to Leveraged Shares
The only alternative to leveraged shares is for those who are non-citizens of the country whose stock they want to trade (in this case, the USA) who can invest in US equities via CFDs and other currency-hedged stocks. For example, I myself am currently holding MSFT CAD Hedged (TSX:MSFT), S&P 500 Equal weight (TSX:EQL), and NASDAQ 100 (TSX:QQEQ.F). I also have holdings in the US equivalents, but as I build the position, I add to the CAD hedged as it permits me to increase my size owing to the cost difference. These exist in many other countries and do the same thing. However, if you are in the US, they are not available because of tax regulations, so your option is to do the underlying or the leveraged shares.
Let’s just look at MSFT (NYSE) vs MSFT (TSX) using the leveraged share indicator:
Not too shabby, huh?
To find which other countries have a currency-hedged version, simply type the ticker into Tradingview’s search bar, and it will come up with the country flag:
Conclusion:
So, are leveraged shares right for you? Well, that’s a personal question, but I hope that you learned how to assess whether or not a leveraged share is right for you with the information provided.
In general, these are the things you should absolutely, 100% think about before investing (key word is investing, not day trading; investing implies holding for greater than 2 to 3 months) in leveraged shares:
1. The overall decay that has historically happened with the leveraged share; you can use the indicator I released to help you figure that out, as well as some of the calculations I employed in the post (mind you, the indicator does it all for you ;).
2. The expected volatility of the market. You can gauge this by looking at historical volatility indicators and also the VIX. The fear and greed index are also helpful as well.
3. Whether your entry price is good or bad. This is something that comes with time and experience as a trader, but I can give you an example of a bad entry for me and why I chose to invest in MSFT CAD hedged as opposed to the leveraged counterpart NYSE:MSFU:
I entered on that candle. You may think it’s a good entry and perhaps it's not the worst entry, but the fact is, things are pretty over-extended on tech and it could go bad really quickly. A more ideal entry would have been:
There. But alas, you have to work with what is given when it comes to investments most times. Though I can’t complain since I am still holding MSFT shares I bought in 2022 at around $242 haha.
Not all leveraged shares are created equal, some are awful *cough* BOIL *cough*, others are great (i.e. UPRO). Make sure you are checking its historic performance, I cannot stress this enough!!
Also, if you are interested in a deeper look on this subject, SpyMasterTrades did an excellent video explanation of the dangers of leveraged shares, you can view it below:
And those are my thoughts! Hope you enjoyed; leave your comments/questions below and, as always, safe trades!
What is a leveraged share?
A leveraged share or leveraged ETF is an ETF that aims to increase exposure to a specific underlying asset. For example, UPRO aims to return 3 times the amount of the S&P. So, in theory, if the S&P were to return 10%, UPRO should return 30% (3 x 10).
How it does this is by using instruments such as options and futures contracts to leverage the exposure to the underlying asset. Of course, this comes with some risks, such as if the ticker goes against you as well as the costs involved in the management and labor of such a task.
Let's take a deeper look at how leveraged shares work by looking at UPRO:
UPRO is the 3x bull leveraged share of the S&P 500. Compared to SPY, it tracks it very well. The average drift (the amount the share may vary in cost compared to the underlying) is about $1 after 10 days, but peaks at a max of around $3 after 252 (1 trading year) days. This means the decay you can expect to experience holding UPRO for 1 year is about a $3 decay per share.
Let's say you entered a UPRO position on January 9th, 2023. At the time, UPRO was about $34.62. Let's say you bought 100 shares at $34.62, for a total entry cost of $3,462. As of today, you would be up 59.28%, or a net P&L of $1,965. If you had bought SPY, you would be up 21.91%.
So let's do the comparison. UPRO is 3X leverage, so we would expect our returns to be 3 X 21.91%. To do this, we simply convert the percentages into a decimal place by dividing by 100, then add. So here is the math:
21.91% / 100 = 0.2191 59.28% / 100 = 0.5928
Assuming that UPRO is 3X spy, we would need to multiply SPY by 3:
0.2191 x 3 = 0.6573 Now convert that back into a percentage by multiplying it by 100:
0.6573 x 100 = 65.73%
So, our expected return should have been 65.73%. However, owing to the decay, it was around 59.28%, with a loss of around 6.45%. This 6.45% is equal to about a $223.30 loss of our initial investment ($3,462 x 6.45% = $223.30). Considering we bought 100 shares, that would be about $2.23 per share, well within the indicator’s prediction of decay.
Now, it's unfair to view this as a loss or "decay" in some circumstances because you are essentially paying for a firm to manage the exposure of the share to the S&P. So this "cost amount" can actually be viewed as a cost of labor, no different than paying a management firm to manage your portfolio for you.
That said, leveraged shares, as investment mechanisms, are only good as investment mechanisms when the markets are good. Let’s take a look at what would have happened if we would have invested in UPRO on March 14th, 2022, during the 2022 bear market decline:
This would be a total of 457 trading days, or roughly 2 trading years.
At the time, UPRO was $52.06. If we did 100 shares at $5,206, we would just be recovering now, vs. us having bought SPY, we would be up 11.90% now:
So what happened here?
Volatility. And this is why, I think, people draw the comparison between options and leveraged shares, because if the trade goes against you for a prolonged period of time and a very dramatic fall, the share is going to decay like mad. What causes this is often referred to as “Beta Slippage.” It is a compounding effect of daily rebalancing in leveraged exchange-traded funds. This happens because, as indicated before, in order to gain the exposure they do, leveraged shares hold derivatives such as options and futures contracts to increase their exposure to the underlying asset.
To understand Beta Slippage, let’s use a made-up example. We have share X, at a value of $40, which has a 2X leveraged bull share, Y, at a value of $8. You buy 100 shares of Y for a total of $800. The next day, X goes up 10%, and your position goes up 20% (2 x Bull). You now have $160 in profit, for a total value of $960. You don’t sell because you believe it will go up an additional 20%. However, over the coming days, X falls about 9.5%. This would translate to a 19% fall on Y (9.5 x 2). If we do the math:
$960 x 19% = $182.4
960 – $182.4 = $777.6
You now have $777.6, which is less than your initial investment. This is the compounding effect.
What if you just invested in the underlying?
$40 x 20% = $48
$48 x 9.5% = $43.44
So, had you invested in 100 shares of the actual underlying, you would still be up $3.44 per share.
The bright side:
The bright side to this is, beta slippage is much easier to account for, track, and calculate with leveraged shares vs options. The phenomenon happens with both instruments, but it's much more nuanced to calculate with options.
When does Slippage show up?
It can show up as soon as the same day if the decline or rise happens starkly and fast enough, but in general, if you are picking a stable ETF like UPRO, it tends to be noticeable at 30 to 50 days:
In the example above, I picked a period consisting of 30 days where SPY was whipsawing like mad. For the most part, UPRO remained fairly stable until day 30 when you can start to see slippage appear. For example, SPY was able to fill the gap (first blue circle) at $447.71, but UPRO failed to fill its gap. SPY then broke above the immediate resistance at $448.71; however, this same resistance on UPRO was not broken.
If we look at the decay tracker indicator, we can see as time passes, not only does the drift in price variation increase but also the slippage increases:
A mention of inverse leveraged shares
I think it’s important to mention inverse leveraged shares. They are viewed, generally, as riskier than bull leveraged shares, and, to an extent, this is true, but not for the reasons you may be thinking. Inverse leveraged shares are victims of the same mathematical and compounding faults as their bullish counterparts, no more and no less. The main risk associated with inverse leveraged shares is the perma-bull thesis, i.e., stocks only go up. And this thesis has proved pretty factual, especially towards the end of 2023.
That said, I have personally held inverse leveraged shares (specifically, SPXS) for roughly 6 months, from April till September during the 2022 decline when I was targeting 350 on SPY. The end result? Some decay resulted, but I still gained just over 40%. There was a little stint where, despite SPY not going up as high as it did before, my position still went red (see chart below):
But quickly recovered. This actually was a wakeup call to always set a trailing stop and take profits when you’re up! I was too confident there. But besides that point, you can see that it did work out holding it a bit longer term.
That said, if we look at SPY vs SPXS using the decay tracker, here are the results:
We can see that there is substantially more slippage on SPXS vs UPRO. Why? Because of the compounding factor. SPY has been in a massive uptrend since October, constantly pushing up and up. This compounds the losses on an inverse leveraged share and increases the slippage with the wild up moves followed by very little pullback. And that is the danger of inverse leveraged shares because you are fighting against a predominant market mantra, ONLY UP, NEVER DOWN.
Alternatives to Leveraged Shares
The only alternative to leveraged shares is for those who are non-citizens of the country whose stock they want to trade (in this case, the USA) who can invest in US equities via CFDs and other currency-hedged stocks. For example, I myself am currently holding MSFT CAD Hedged (TSX:MSFT), S&P 500 Equal weight (TSX:EQL), and NASDAQ 100 (TSX:QQEQ.F). I also have holdings in the US equivalents, but as I build the position, I add to the CAD hedged as it permits me to increase my size owing to the cost difference. These exist in many other countries and do the same thing. However, if you are in the US, they are not available because of tax regulations, so your option is to do the underlying or the leveraged shares.
Let’s just look at MSFT (NYSE) vs MSFT (TSX) using the leveraged share indicator:
Not too shabby, huh?
To find which other countries have a currency-hedged version, simply type the ticker into Tradingview’s search bar, and it will come up with the country flag:
Conclusion:
So, are leveraged shares right for you? Well, that’s a personal question, but I hope that you learned how to assess whether or not a leveraged share is right for you with the information provided.
In general, these are the things you should absolutely, 100% think about before investing (key word is investing, not day trading; investing implies holding for greater than 2 to 3 months) in leveraged shares:
1. The overall decay that has historically happened with the leveraged share; you can use the indicator I released to help you figure that out, as well as some of the calculations I employed in the post (mind you, the indicator does it all for you ;).
2. The expected volatility of the market. You can gauge this by looking at historical volatility indicators and also the VIX. The fear and greed index are also helpful as well.
3. Whether your entry price is good or bad. This is something that comes with time and experience as a trader, but I can give you an example of a bad entry for me and why I chose to invest in MSFT CAD hedged as opposed to the leveraged counterpart NYSE:MSFU:
I entered on that candle. You may think it’s a good entry and perhaps it's not the worst entry, but the fact is, things are pretty over-extended on tech and it could go bad really quickly. A more ideal entry would have been:
There. But alas, you have to work with what is given when it comes to investments most times. Though I can’t complain since I am still holding MSFT shares I bought in 2022 at around $242 haha.
Not all leveraged shares are created equal, some are awful *cough* BOIL *cough*, others are great (i.e. UPRO). Make sure you are checking its historic performance, I cannot stress this enough!!
Also, if you are interested in a deeper look on this subject, SpyMasterTrades did an excellent video explanation of the dangers of leveraged shares, you can view it below:
And those are my thoughts! Hope you enjoyed; leave your comments/questions below and, as always, safe trades!
For real-time updates and premium indicators, consider joining my group at: patreon.com/steversteves
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