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Leveraged ETFs, or exchange-traded funds, are investment funds designed to amplify the returns of an underlying index or asset class through the use of financial derivatives and debt. These ETFs aim to achieve returns that are a multiple of the performance of the index they track, typically two or three times (2x, 3x) the daily performance.
There is evidence that 1x ETF options provide an indication of the future return of the underlying 1x ETF. Reference [1] goes further and postulates that options on leveraged ETFs provide an even stronger indication of the 1x ETF future return. The authors pointed out,
This study examines the informational content of options on leveraged ETFs and their ability to predict the performance of the underlying ETF. We argue that sophisticated traders, who prefer leveraged securities, are likely to trade leveraged ETFs to capture broad market exposure. Consequently, to effectively hedge or speculate on these leveraged positions, informed investors might turn to options on leveraged ETFs. Following this reasoning, we construct a measure of informed trading in these options using innovations in the implied volatility of call and put options on leveraged ETFs.
Our results provide strong empirical support for our proposition. Specifically, we document that both levered and unlevered option signals predict future returns of the underlying ETFs. While both signals are statistically significant, the economic significance of the levered signal is notably stronger. For instance, a $1 investment based on a levered signal for SPY produces a net return of $27.59, adjusting for transaction costs, over the period from 2009 to 2021. Our findings highlight the importance of leveraged products, particularly options on leveraged ETFs, in price discovery within the market.
In short, by using the difference in implied volatility innovations between calls and puts of leveraged ETFs as a trading signal, one can gain excess returns.
Let us know what you think in the comments below or in the discussion forum.
References
[1] Collin Gilstrap, Alex Petkevich, Pavel Teterin, Kainan Wang, Lever up! An analysis of options trading in leveraged ETFs, J Futures Markets. 2024, 1–17
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