Trading Leveraged ETF's with margin? What's the math?

Discussion in 'ETFs' started by OctopodeClub, Jan 26, 2017.

  1. Most brokers require you to maintain a margin minumum when trading leveraged ETF's. For example, requiring 50% margin on 2x Etf's.

    In essence, doesn't this mean that you would only be 1.5x (200-50%) leveraged with a 2x ETF?

    I'm trying to figure out the best combination for short term day/swing trading;
    -With/without margin
    -Standard vs leveraged ETFs
    - Or both, using margin AND leveraged ETFs

    I'm thinking using leveraged ETFs WITHOUT margin might be the cheapest option.
  2. try futures instead of over complicating with ETFs
  3. H2O


    Think about this yourself for a minute...

    What does 50% margin required by your broker mean? - Your broker allows you to utilise DOUBLE the amount of cash in your account. Now if you use this to purchase an instrument that seeks to match 2x the return on an index, you're effective exposure is now 4x your cash.

    (Note this is the same as buying a regular equity, for which your broker has a 25% intraday margin requirement.)
  4. toonerdy


    Hmm... The 8% annualized margin interest charged by some of the more expensive brokerages works out to about $2.11 for each of 365 calendar days or $3.08 for each of 250 trading day for every $10,000 borrowed (because 1.08 ~= 1.000308 ** 250 ~= 1.000211 ** 365). So, yeah, maybe it does matter. Shop around.

    Besides offering glib advice to shop around, I will try to answer the original poster's question. Just please keep in mind that I don't have any kind of certification to advise anyone on this. This is just my layman's understanding.

    One point that the original poster may be referring to is that the term "margin interest" can be misleading. In a normal margin account, you are not charged for using margin; you are charged for borrowing cash. So, if a brokerage charges a lot, say 8%, to borrow cash, that can easily exceed the leveraged ETF's fees, say ~1% for SPXL, less SPY ETF's 0.1% fee multiplied by the 3X leverage factor for 0.3% (all percentages are per year).

    For example, starting with an account consisting entirely of $10k cash, buying $20k of an unleveraged ETF or $10k of a 2X levaraged ETF may have the same margin requirement, but only the former will incur margin interest, in the absence of any other trades.

    Regarding the original poster's idea of using margin and leveraged ETF's together, one could avoid borrowing cash by shorting $1 of a -1X ETF for every $5.20 of the corresponding 3X ETF (by solving initial_cash = long - short = (long x 3 x 25%) + (short x 30%)), assuming margin of 25% for long positions (75% for a 3X ETF), 30% margin for short positions, no bid-ask spreads, no commissions, no slippage, avoiding 50% regulation T end of day initial margin requirements (perhaps by not holding overnight), clairvoyance to know that the underlying will not drop by even one tick below the entry until exit, and the really unlikely possibility that I have not botched the math. [Edit: Thanks to Sig for pointing out that shorting the -1X ETF would incur stock borrowing costs.]

    Before you embark on a strategy of holding leveraged ETF's across rebalancing periods (usually daily), you should definitely read about decay of leveraged ETF's, often called "volatility drag." The losses from that can be huge. Occasionally, LETF's can outperform their target leverage (for example, SPXL tracks 3X SPY daily, but I believe has gotten almost 4X SPY's total return since election day). However, leveraged ETF's have been shown usually to decay substantially under some reasonable statistical assumptions about the movement of the underlying--according to one paper [1], exponentially at a tempo proportional to, among other parameters, variance (that is, volatility squared) and L*L - L, where L is the leverage factor (L*L-L works out to zero for L=0 or +1, 4 for L=-1 or +2, 6 for L=+2 or -3, and 12 for L=-3).

    This is not to say that leveraged ETF's have expected values below their prices, just that they evolve into directional lottery tickets, like some option positions, which, by the way, is another possibility for leverage, along with recession2016's suggestions of considering futures, both of which have their own costs, risks and potentially costly fallacies. Be careful.

    [1] , page 10, equation 2.1.4.
    Last edited: Jan 27, 2017
    OctopodeClub, Sig and dealmaker like this.
  5. Sig


    Great post. I would add not to forget the borrow cost for shorting that inverse ETF as well.
  6. toonerdy


    Thanks, Sig. I was still allowed to edit that post, so I have added an acknowledgement of your point into it. Thanks for improving it.
  7. Stymie


    All of these leveraged ETFs have a prospectus that's hundreds of pages long. In there you find How they hedge these products with OTC derivative's traded with related counterparties that Mark up spreads and take money from investors. The long-term returns look the same as buying short-term option premium. If you do anything in these, you want to buy OTM put vertical spreads but only if they are liquid. Aim for four times return on your risk. You never want to buy these products as a long-term investment. The time to K will kill you.
    OctopodeClub likes this.
  8. toonerdy


    With my deepest apologies, I retract the preceding paragraph. Money raised from a short sale of stock is not available for buying other stock because that money and apparently even a little extra is given as collateral to whoever is lending the stock. If anyone tried to implement the idea in the preceeding paragraph, they were probably charged margin interest.

    Rather than suggest that anyone rely on my credibility on this topic at this point, I'll just quote a web page from Interactive Brokers at :
    I am very sorry for have spread my misunderstanding about that on this forum. If you passed my wrong idea along to anyone, I ask your help in updating them to minimize any, if you'll pardon the pun, collateral damage.