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.
Leveraged products carry several distinct risks, and the risks are more common than the corresponding rewards. The list below is the order of frequency for retail traders, and the order is roughly the order in which the risks catch the trader out. A new trader is most likely to be caught by the daily reset drag. An experienced trader is more likely to be caught by the gap risk or the behavioural trap.
The daily reset drag
The daily reset drag is the most common risk, and the most insidious. 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 drag is most pronounced in a sideways market with high realised volatility. The result is a slow decay that the trader does not see in the daily P&L but accumulates in the monthly P&L. 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.
The gap risk
The gap risk is the second most common risk. 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 6% loss on a 2× leveraged product before the trader has a chance to react.
The 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 be out of the position over a known event, or to size the position to the gap risk rather than the daily risk.
The financing cost
The financing cost is the third most common risk. 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 financing cost is the most common reason that leveraged products underperform the underlying over long horizons. The cost is not visible in the daily P&L, but it shows up in the year-end return. The fix is to hold the product for a short period, where the financing cost is small.
The margin call risk
The margin call risk is the fourth most common risk. 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 fix is to size the position to the maintenance margin, not the initial margin. A trader who sizes the position to the initial margin alone has no buffer for a gap, and the gap triggers a margin call. A trader who sizes the position to a 20% gap on the position has a buffer for most gaps, and the margin call is less likely to fire.
The behavioural trap
The behavioural trap is the fifth most common risk, and the hardest to manage. 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 trap is the most common reason that small losses become large losses. The trader who closes a leveraged position at the stop, takes the loss, and moves on to the next trade is using leverage correctly. The trader who moves the stop, adds to the position, and watches the loss grow is using leverage incorrectly, and the trader is the one who is exposed to the large loss.
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. 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 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.