Can You Lose More Than You Invested with 3x Leveraged ETFs? Understanding the Risks and Limitations
Understanding the Mechanics of Leveraged ETFs
When it comes to leveraged ETFs, especially those with a 3x daily multiplier, there is a common misconception that one can lose more than the initial investment. Many believe this because the returns are compounded daily. However, this is not entirely accurate.
The primary principle to remember is that the leverage is based on a percentage return of the underlying index on a daily basis, and therefore, these percentages cannot fall in value below zero. Hence, no matter how volatile the underlying index, you cannot lose more than your initial investment in a leveraged ETF.
For example, if an ETF starts at $100 and the leverage is 3x, the ETF may rise to $300 or fall to $0 over time. However, it cannot go below zero due to the nature of percentage returns. This is a crucial point many investors overlook.
3x ETFs vs. Daily Multipliers
It is important to understand that 3x leveraged ETFs do not aim to provide 3x the returns over a longer period; rather, they attempt to achieve 3x the daily return of the underlying index. This distinction is critical and can lead to significant misunderstandings if not properly understood.
For instance, a daily 3x ETF may increase or decrease by a factor of 3 on any given day, but the total compounded return over a period of time might not match the product of the daily returns due to the compounding effect of the daily multipliers.
Incorrectly applying the concept of 3x return over a longer period can lead to losing more than the investment. For example, if you invest $100 in a 3x leveraged ETF and the daily return is -33%, your initial investment would be wiped out in just three days.
Maximum Loss Limitation
When buying leveraged ETFs, such as 3x ETFs, the potential for loss is limited to the initial investment you put in. This is true even if the ETF goes nowhere for a week or two.
For instance, if an ETF starts at $100 and the underlying index remains flat, the ETF might still go to zero. However, the loss is limited to the $100 you initially invested. This is akin to shorting a stock or buying inverse ETFs, which also have the same principle of a maximum loss of the initial investment.
Margin Trading and Higher Risks
It is essential to note that if you trade leveraged ETFs using margin (borrowed money from the brokerage), you can potentially lose more than the initial investment. Margin trading multiplies the losses or gains, so if the market moves against your position, you could end up losing much more than your initial cash investment.
If you buy leveraged ETFs like you would buy stocks, the worst-case scenario is that you will lose your initial investment unless you engage in more complex trading strategies such as options or short selling.
Conclusion
Understandably, the risks associated with leveraged ETFs, especially 3x ETFs, can be substantial. However, if you invest with cash and do not use margin, you are protected from losing more than your initial investment.
The key takeaway is that no matter how volatile the market, the percentage returns on leveraged ETFs cannot fall below zero. Therefore, the maximum loss you can encounter is tied to the initial sum you put into these types of investments.
Stay informed, and always conduct thorough research before engaging in leveraged ETFs.