Part 5: ETPs vs Leveraged Alternatives

Your capital is at risk if you invest. You could lose all your investment.

Please see the full risk warning at https://leverageshares.com/en/risk-disclosures/.

Our Short & Leveraged Single-Stock ETPs could be challenging for some investors looking for new innovative products to add to their portfolio. In this six-part educational series, we describe the idea behind our products, their construction, features and their benefits to investors as well as when compared to other similar-seeming products.

Contents
  1. Warrants vs Our ETPs
  2. Turbos vs Our ETPs
  3. Leverage Certificates vs Our ETPs
  4. Conclusion

European investors are no stranger to trading with leverage. Leverage Shares’ range of ETPs offer an alternative to many other products such as warrants, turbos and leveraged certificates.

In many respects, as we highlighted in Part 1, these alternatives may seem comparable to ours in terms of benefits:

  • The investor’s losses are capped at initial amount invested
  • The investor doesn’t require a margin account to trade
  • The investor doesn’t need to maintain margin levels
  • The investor can rest assured that the products are traded on a regulated exchange

So how do our ETPs stack up against these products? In this part of the series, we highlight the key features of these leveraged products and the distinctions between them and our single-stock ETPs.

Warrants vs Our ETPs

Covered warrants are issued by financial institutions and give the holder the right, but not the obligation to buy or sell an underlying asset, at a specified price (also known as “strike price”), on or before a predetermined date.


Note: These are fundamentally different from traditional warrants, which don’t have “call” (right-to-buy) or “put” (right-to-sell) features and are very similar to a rights issue made to attract investors.

Where covered warrants differ from standard options are that:

  1. They can only be “written” (sold) by an institution, unlike options. For example, when an investor writes a call option, the investor is selling a call, which means that said investor is obligated to deliver a certain number of shares at a set price within or on a specified date to the buyer if that buyer chooses.
  2. They tend to have much longer periods between issue and expiration than options, regularly to the magnitude of years rather than months as with options. Options tend to have a duration ranging anywhere from a week to a few months.

Where covered warrants are similar to standard options are that:

  1. They do not pay dividends or come with voting rights.
  2. They are priced using the same models and principles.

Warrants also have a stated “conversion ratio”, which is simply the number of warrants needed to buy or sell one unit of the underlying. A covered warrant’s leverage is referred to as its “gearing” and is computed as the ratio of the current stock price to the product of the warrant price and its conversion ratio.

There are two primary sources of risk when it comes to covered warrants:

  1. A covered warrant will render profits only when the market price exceeds the strike price for a “call” warrant or is below the strike for a “put” warrant. This is known as “market risk”.
  2. The entirety of an invested amount would be lost if the corporation issuing the covered warrant becomes insolvent. This is known as “counterparty risk”.

Our ETPs, in comparison:

  1. Do not have a “strike price”. Owning a 2x ETP, for instance, is equivalent to paying for one unit of stock and getting twice the exposure (excluding fees). In this scenario, Leverage Shares would physically purchase two units of stock and provide the magnified benefit of price rises or the magnified penalty of price falls. The investor simply purchases a single ETP on a regulated market and receives exposure directly correlated to underlying stock price.
  2. Do not have “premiums” (or options prices). The computation of the premium is in covered warrants is highly sensitive to factors such as:
    • Underlying stock volatility. Our ETPs simply follow the daily performance of the underlying stock.
    • Time to maturity. Our ETPs are rebalanced daily and an investor’s position simply carries over into the next day until and unless the investor chooses to exit.

  3. Have “market risk” that is entirely different and could be considered less complex than what the holder of a covered warrant faces. The ETP simply works to track the underlying stock with no substantial complications.
  4. Have a static leverage factor, unlike the dynamic “gearing” factor in warrants. For instance, our ETPs aim to provide twice the benefit of stock performance in a 2x ETP, reset on a daily basis.

Turbos vs Our ETPs

Less computationally intensive than covered warrants, a “turbo” allows the investor to profit from a rise or fall in the price of the underlying security. The initial investment for a turbo is often lower than that required for direct investment in the underlying for the same absolute return. The rest is supplemented with financing from the product provider – this is the “leverage” in turbos and is their main feature. The higher the leverage, the greater the exposure to the price movement of the underlying asset.

The leverage is determined by selecting a “knock-out” level, i.e. the price at which the turbo becomes worthless. With “long turbos” the knock-out level must be below the current market price of the underlying and vice versa in the case of “short turbos”. The closer the knock-out level is to the current price, the higher the leverage.

To illustrate this feature, assume the underlying is currently valued at €100 in the underlying market, and the investor chooses a long turbo with a knock-out level of €90. The price of the turbo (excluding costs, etc) is 100 – 90 = €10.

If the underlying asset rises by €10 to €110, the turbo will track this new price and its new value will be: 110 – 90 = €20. That is, the initial €10 investment has had a 100% increase in value, effectively delivering a 2x return.

On the other hand, if a knock-out level of €75 is selected, the initial price of the turbo is €25 and its new value will be €35 when the underlying moves to €110. This is, by comparison to the earlier case, only a 40% increase in value. Needless to say at this point, if the underlying falls to €90 or below, the value of the turbo is now zero and the initial investment made is effectively lost.

Our ETPs, in comparison:

  1. Do not have a “knock-out level”. The investor is provided by the benefit or penalty of the underlying’s price movement multiplied by the leverage factor and the effects of daily compounding.

    Note: This applies even in the event of an investor’s preferred broker offering fractional ownership of our products.
  2. Have a redefined form of “market risk”, just as with warrants, which may be considered far less complex for the investor.

  3. Note: There’s a hybrid of warrants and turbos called a “turbo warrant” (also known as a callable bull/bear contract). It is essentially a barrier option and has both features compounded and is typically very highly geared on account of high knock-out probabilities. The arguments made in favour of our ETPs over warrants hold true, even when compared to turbo warrants

Leverage Certificates vs Our ETPs

Leverage certificates are structured financial instruments that offer investors a fixed leverage factor on the daily performance of the underlying asset. Like our ETPs, they:

  1. are rebalanced on a daily basis
  2. have an airbag feature that is triggered when the underlying falls a certain amount in a single day.

The language employed to define leverage certificates can be confusing: Constant Leverage Certificates replicate the performance of the underlying asset multiplied by the leverage factor and the loss is limited to the initial amount invested, just like our ETPs.

Variable Leverage Certificates, on the other hand, assign the right to buy (bull) or sell (bear) an underlying asset at an established strike price and date (“time to maturity”). This is very similar to covered warrants and unlike our ETPs, which simply offers exposure to the performance of the underlying multiplied by the leverage factor without a “time to maturity” feature.

However, like our ETPs, variable leverage certificates also offer price matching between the underlying and certificate’s intrinsic value along with independence from volatility of the underlying.

Unlike our ETPs, Variable Leverage Certificates have the following features:

  1. a “stop loss” level, which, if reached or exceeded by the underlying during the life of the certificate, causes the instrument to expire in advance, limiting the loss to just the invested amount.
  2. a daily variation in strike price with interest charged (bull certificate) or credited (bear certificate) by the issuer included.

However, compared to our ETPs, leverage certificates (both Constant and Variable) suffer from:

  1. Credit Risk:
  2. When buying leverage certificates, the investor is buying a product backed by nothing other than the creditworthiness of the issuing entity, with no specific assets guaranteeing the return of those products. If the issuer defaults (as Lehman Brothers did in 2008 and others throughout the years), its leverage certificates are likely to expire worthless. This is called “credit risk”. Our ETPs, by contrast, are backed by the physical holding of underlying assets which are segregated from Leverage Shares (in other words, Leverage Shares cannot use those underlying assets, they are held by an independent trustee for the benefit of our investors).

  3. Liquidity risk:

    The secondary market of leverage certificates may be illiquid, making it harder for the investor to buy or sell them when they want to. By contrast, our ETPs have multiple market makers and a dedicated market maker, independent from and paid by the issuer to provide liquidity continuously during at significantly tighter spreads and greater minimum amounts than are required by the exchange.

  4. High (and often) hidden costs:

    Leverage certificates have a complex cost structure that include management fees and, if held overnight, additional costs such as the spread on the bid & ask prices of the underlying, a “gap premium” for the hedging cost to prevent a loss greater than the initial investment as well as funding and rebalancing costs. In comparison, our ETPs have a very simplified and transparent structure of costs

Also, when specifically compared to Variable Leverage Certificates, our ETPs do not have a stop loss level or a daily strike price being set. This, like in previous comparisons, helps to redefine and simplify market risk and product complexity for the investor

In Conclusion

All of the products discussed here in relation to our ETPs don’t need margin accounts or margin level maintenance, have fairly competitive and transparent pricing mechanisms and are quite popular among European investors.

However, key differences must be noted:

  1. The likes of warrants and turbos have a lot of commonalities with the payoff structures of various types of options. Derivatives are inherently “high-risk/high-return” products with complex risk factors; our ETPs work as an analogue to equities and, thus, aim to simplify.

  2. While leverage certificates do simplify the risk factors relative to warrants and turbos, there is still the prospect of counterparty risk. Our physically-backed ETPs eliminates this source of risk as well and offer comparably-priced alternatives to leverage certificates in the bargain.

  3. There is a lot of emphasis on the institutions to provide the appropriate pricing for these products during the trading session. Our single-stock ETPs have market makers offering very competitive pricing during exchange hours.

We believe our physically-replicated ETPs are the latest stage in the evolution of leverage products: we take the best features from the products that have been with us for decades and improve on them through superior pricing, risk reduction and liquidity, delivering a better all-round investor experience. If one were to analyse risks and costs, the summary of benefits in favour of our single-stock ETPs versus these alternatives can be summed up as follows:

Your capital is at risk if you invest. You could lose all your investment.

Please see the full risk warning at https://leverageshares.com/en/risk-disclosures/.

Education Series: Single-Stock ETPs

Authored by

Sandeep Rao

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