Risks of Trading ETFs
Hello, traders. Welcome to the stock trading course and the fifth module, Day Trading ETFs.
In this lesson we’re going to talk about the risks of trading ETFs, and we’re going to actually mention why it is not safe to swing trade or to hold ETFs as an investment tool. But let’s start by the risks associated with trading ETFs. And remember that when you’re trading the financial markets, there are always risks. And trading is just putting your money at risk to make a positive return on a great risk to reward scenario, but it’s always a good thing to understand the risks of the instruments that you’re trading.
So the first thing that I want to talk about is holding ETFs overnight, this can be tricky. Now, leverage ETFs can be tricky to medium trade. I’m saying that it can be tricky to medium term trade, but I’m not saying that you should not medium trade it, because…well, remember that leverage ETFs amplify the return of the underlying asset, and if you are riding a big bull market or a big bull short-term market in the S&P 500 by buying the spy, you can hold it until the short-term bull market ends. But it can be tricky, and I’m going to show you why.
Suppose you buy a two-times leverage ETF worth $1,000 at the beginning of the session, and at the end of the session or at the end of the day, it ends up 10%. Your position will now be worth $1,200 for a 20% profit, because you bought a 2x leverage ETF. So that’s great. But imagine that the next session the ETF falls 9.3%, your position will suffer from a loss of 18.6% percent, which doesn’t sound as bad because you made 20% the day before. Now, let me show you the math behind this. An 18.6% loss on a $1,200 position will mean a net loss of $204.60, putting your position at $995.40 for a loss on your original investment for $4.60. So it can be tricky to hold leverage ETFs overnight, because the 2x leverages worked both ways.
The other risk of trading ETF is compounding. And the definition of compounding is generating profits from previous profits, okay? Now, let’s understand compounding from the example above. Let’s take this $1,000 investment of a 2x leverage ETF, and your position ends up 20% up because it’s a 2x ETF, so your position is now worth $1,200. Let’s say that the next day the leverage ETF rallies another 20%. Your position would now be worth $1,440 and not $1,400 because of compounding it because you’re not starting the second day with $1,000, but you’re starting the second day with $1,200.
So leverage ETFs can generate big profits from compounding but also can generate big losses if the position is not managed correctly. Imagine if the leverage ETF moves up and down by 10% every two days and the trader continues to hold the position. This means that you’ve bought a leverage ETF but the position does nothing but going up 10% every two days, and going down 10% every two days. So the first day you’re up 10%, but the second day your position that was up 10% was down 10%, but then again on the third day it goes up 10%. So, well, the underlying asset is trading in a range, but the leverage ETF is moving up and down 10% every two days because of the range that the underlying is trading in. The underlying security might be flat because it’s trading in a range at the same price, but the ETF might be down 40% to 50% by compounding.
So in this module I’m going to teach you how to trade ETFs, and you’re going to see that when we’re trading ETFs we actually are going to look for a volatility, for big moves. We’re going to ride those big moves to multiply our profits, but we are going to close our positions once the market starts to flatten, because we don’t want to lose money to compounding.
ETFs are not investment tools, and this is very important. Leverage ETFs can be an attractive long-term investment tool because of their low costs and the ability to amplify returns. But, as we saw on the previous examples, there are great risks to holding them over a long period of time as an investment. So EFTs and leverage ETFs are a great tool for active traders like us, but investors have to stay away from them.