This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
A leveraged asset is a financial instrument that produces a multiple of the return of an underlying asset. The category includes leveraged ETFs, leveraged ETPs, leveraged CFDs, leveraged warrants, single-stock futures, and any margin position where the leverage is set by the broker. The risks and rewards are common across the category, even though the products have different mechanics, different regulators, and different cost structures.
The reward side
The reward is the multiple. A 2× leveraged S&P 500 ETF produces twice the daily return of the S&P 500. A 5× leveraged CFD on a US stock produces five times the daily return of the stock. A warrant with a 5:1 gearing produces five times the daily return of the underlying. The multiple is the headline, and the trader who is right about the direction of the underlying is rewarded with a multiple of the return.
The reward is most valuable in a short-term tactical position. A trader with a multi-day view on a specific sector can use a 2× leveraged sector ETF to size the position to the view, rather than holding a basket of stocks and rebalancing. The product is the trade. The financing cost on a multi-day hold is small, and the daily reset is not a meaningful drag.
The reward is also valuable in a hedging context. A short position in a 1× inverse product is a clean way to hedge a long portfolio through a known risk window. The cost is the financing rate plus the tracking error, which is usually small for the major indices.
The risk side
The first risk is the daily reset. A leveraged product that targets a daily multiple of the underlying rebalances at the close. In a flat or choppy market, the daily reset compounds in a way that produces a return below the cumulative return of the underlying. The effect is small per day and large over weeks.
The second risk is the gap. The product is rebalanced at the close, but the trader may hold through a gap at the next open. A 3% gap down on the underlying produces a loss on a 2× leveraged product of 6% before the trader has a chance to react. The rebalance did not happen, and the trader's stop did not fire at the right level.
The third risk is the financing cost. A leveraged product held overnight pays a financing rate on the borrowed portion. The rate is published on the broker's product page, and it accrues daily. For a 2× leveraged position, the financing cost is roughly half the broker's margin rate. Over a year, the cost is meaningful.
The fourth risk is the margin call. A leveraged asset held on margin is subject to a margin call if the position moves against the trader. The margin call fires at the maintenance margin level, and the trader is asked to deposit more cash, close part of the position, or both. If the trader does not respond, the broker closes the position at the worst available price.
The fifth risk is the behavioural trap. A trader who is up on a leveraged position is reluctant to take the profit, because the return feels too small for the leverage. A trader who is down on a leveraged position is reluctant to take the loss, because the loss feels too large for the trade. The result is a position that is held too long in both directions.
The asymmetric distribution of returns
The same statistical effect that makes a leveraged portfolio more volatile in theory also makes it less profitable in practice, over long horizons. The distribution of daily returns on most assets is slightly skewed to the left, with more small losses than small gains and more large losses than large gains. The leverage amplifies the losses more than it amplifies the gains, because the losses are larger in percentage terms and the leverage is a percentage multiplier. The result is a leveraged return distribution that is shifted to the left of an unleveraged one, and the shift is larger for higher leverage ratios.
This is the academic reason that leveraged ETFs underperform their underlying over long horizons. The product is fair on a daily basis, but the daily reset in a non-symmetric distribution produces a long-run drift to the downside. The same effect applies to a leveraged portfolio held for the long term.
How to manage the risks
The honest answer is to size the position to the stop and the account, and to hold for a short period. The risk of a leveraged asset is most acute when the asset is held for a long period, the position is unhedged, and the trader is using the leverage to take a position larger than the unleveraged position would have been.
A useful discipline is to set a target and a stop before the trade is opened, and to honour them when the price reaches them. The discipline is the same as for an unleveraged position, but the stakes are higher. A trader who is using leverage should be more disciplined, not less, and the discipline is the only way to make the leverage work in the trader's favour.
Related resources
Where to start
If you are comparing brokers for leveraged asset access, the most useful features are the leverage ratio, the financing rate, the maintenance margin, and the eligible instruments. Our broker comparison lists the leverage available at each broker and the regulator that supervises the account, which together tell you what the cost and the risk look like before you size the position.