Lever up! An analysis of options trading in leveraged ETFs

Abstract

We examine options trading in leveraged Exchange-Traded Funds (ETFs) and their impact on the performance of the underlying funds. Using implied volatility innovations in call and put options, we demonstrate that option signals from leveraged ETFs are robust predictors of the underlying ETFs' performance. While both levered and unlevered option signals forecast ETF returns, the levered signal is more pronounced in both magnitude and relevance. This predictivity power primarily stems from inverse leveraged ETFs and during economic downturns. Furthermore, we use the leveraged ETF option signals to develop a trading strategy that produces an average abnormal performance of 1.13% per month.