Leveraged SpaceX ETFs Are Exploding in Popularity. That's Usually a Warning Sign.

Space Exploration Technologies (NASDAQ: SPCX) had the largest, most anticipated IPO in history, turning Elon Musk into the world's first trillionaire. Many investors piled into SpaceX ahead of the IPO to get a piece of the action, which has also boosted demand for leveraged SpaceX ETFs.

When leveraged ETFs explode in popularity, it's time to take a step back and reassess the stock market. It's a red flag when a lot of money rushes into leveraged ETFs, which can have consequences for broader market participants.

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Leveraged ETFs tap into greed and euphoria

Leveraged ETFs fulfill their objective nicely. They provide 2x or even 3x exposure to a stock. Some leveraged ETFs offer additional exposure to upside movements, while others give you more exposure to a short position.

You can't be a risk-averse investor if you buy leveraged ETFs, which is part of the problem. The people who buy leveraged ETFs are willing to take substantial risks that work well in a bull market but hurt tremendously in a bear market.

Also, remember the nature of leveraged ETFs. They are financial products that provide leverage, and someone comfortable with these funds may also trade options and borrow money on margin. Too much of that activity turns the stock market from a steady engine of growth into a house of cards due for a big dip, and margin accounts are heading in that direction.

Margin debt increased by 53.7% year over year to reach a record $1.42 trillion. It's the second consecutive monthly increase as investors shrug off the conflict in Iran, and an 8.5% sequential growth rate on top of that.

Broad margin unwinds can be deadly

Bulls make money, bears make money, and pigs get slaughtered. The saying captures what happens when margin starts to unwind during the correction: Accelerated losses always start with the slaughters.

Leveraged ETFs can be a gateway into margin accounts, options, and other high-risk assets. An investor who is deep into margin and leveraged ETFs will be forced to sell some of their shares at a permanent loss to fulfill margin call requirements. A broker can sell stocks without asking for your permission and at any time if you have a margin account.

A 5% dip is enough to force margin calls on the most euphoric investors, and their forced selling can trigger a deeper dip that forces them to sell even more shares. Their selling puts downward pressure on stocks and may force people with high margins but who are slightly more cautious to sell some of their positions.

This cycle will continue until investors who use leveraged financial products sell a significant amount of their holdings so they do not have to sell anything else. Some people get out of the margin entirely after seeing the losses they incurred in a short period of time. Then, the stock market has an easier path to recovery.

What should investors do in this situation?

Leveraged ETFs and margin don't go up forever. When they lose value, investors are forced to sell funds and assets that they planned to hold for a long time. Even if they hold their positions, high expense ratios and margin rates on leveraged ETFs eat away at the portfolio.

Investors who do not use these financial products will still be affected, as it will show up in volatility. Leveraged ETFs amplify price movements of underlying stocks and can introduce traders to risky products like margin and options that increase leverage. What would normally be a 1% price swing may turn into a 2% or 3% price swing, especially for growth stocks.

Even as financial markets become more complex and funds offer more nuanced offerings, the path to success remains the same. Focus on stocks with solid fundamentals that you would be comfortable holding for the next decade. A broad market correction does not change the fundamentals of your favorite stocks.

The extended market corrections leverage allows savvy investors to buy their favorite stocks at lower prices. SpaceX leveraged ETF demand shows we are in a euphoric, greed-driven cycle that will eventually correct, but that's no reason to sell everything and panic.

Marc Guberti has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.