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.
The risks of leveraged products are well-known, well-documented, and well-ignored. The retail trader who buys a 2× or 3× leveraged ETF as a long-term hold is the most common case. The retail trader who uses a leveraged CFD as a multi-month position is the second most common. The retail trader who holds a leveraged product over a weekend is the third. In all three cases, the trader is taking on risk that the product was not designed to carry, and the result is usually a drawdown larger than expected.
The daily reset risk
The most common risk is the daily reset. Leveraged products that target a daily multiple of the underlying rebalance 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. A trader who holds a 2× leveraged S&P 500 ETF for a year in a choppy market can produce a return well below 2× the underlying's return, sometimes negative while the underlying is positive.
The risk is most pronounced in a sideways market with high realised volatility. The daily moves are large in both directions, and the product is rebalanced into each move. The result is a slow decay that the trader does not see in the daily P&L but accumulates in the monthly P&L.
The gap risk
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 gap down on the underlying of 3% at the open 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 because the stop was set on the previous close.
A gap risk is most acute over a weekend, a holiday, or a known event. The trader is exposed to the gap for the entire closed period, and the leveraged product amplifies the gap. The fix is to size the position to the gap risk, not to the daily risk, and to be out of the position over a known event.
The financing risk
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. For a 3× leveraged position, it is roughly two-thirds. Over a year, the cost is meaningful, and it is paid whether the trade wins or loses.
The financing cost is the most common reason that leveraged products underperform the underlying over long horizons. A trader who holds a leveraged product for a year and produces a 10% gross return on the underlying produces a return of 10% × leverage ratio minus the financing cost. The cost is not visible in the daily P&L, but it shows up in the year-end return.
The margin call risk
The fourth risk is the margin call. A leveraged product that is held on margin, rather than as a fully funded position, 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, locks in the loss, and charges a fee.
The margin call risk is most acute in a fast market, where the position can move through the margin call level before the trader has a chance to react. The forced close locks in the loss, and the recovery is not possible from the closed position. The trader is left with a smaller account and a worse view of the market.
The behavioural risk
The fifth risk is the behavioural one. 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, often with the trader adding to the position at the worst moment.
The behavioural risk is the hardest to manage, because it is not visible in the product mechanics. The fix 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.
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 product is most acute when the product 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 leveraged product used as a short-term tactical tool, with a tight stop and a small percentage of the account at risk, is a fair product. A leveraged product used as a long-term investment is a destructive one.
Related resources
Where to start
If you are evaluating a leveraged product for your portfolio, the most useful features to compare are the leverage ratio, the daily reset policy, the financing cost, and the maintenance margin. 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.