Best inverse and short ETFs — here’s what to know before buying them
Inverse exchange-traded funds (ETFs) are often used by contrarian traders looking to profit from the decline in value of an asset class, such as an index. These risky investments, also known as short ETFs, can be valuable for seasoned market pros as increased volatility provides short-term opportunities to get in and out of positions. However, while these investments can potentially be lucrative, they are definitely not for everyone.
Depending on your financial situation and risk tolerance there are various strategies for trading inverse ETFs. For example, some traders use short ETFs to hedge against falling prices in other positions. So, as one position drops, the other one rises, capping the potential losses.
Investors should note that inverse short ETFs reset daily. So, holding them for longer than a day could compound the potential losses.
Your level of financial knowledge and engagement with your investments are important factors to consider carefully. Even experienced traders often start small and have an exit strategy. The key is to stick to your plan and know when to close out of a losing position.
Below we highlight some of the most popular short ETFs, explain the concept of short selling and leveraged trading, and discuss some key considerations to keep in mind if you’re thinking about buying an inverse ETF.
Top inverse ETFs
The following inverse ETFs, also known as short ETFs, are some of the most widely traded.
ProShares UltraPro Short QQQ (SQQQ)
SQQQ offers three times daily downside leveraged exposure to the tech-heavy Nasdaq 100 index. This ETF is designed for traders with a bearish short-term view on large-cap technology names.
Fund issuer: ProShares
Expense ratio: 0.95 percent
Average daily volume: ~70 million shares
Assets under management: ~$1.75 billion
ProShares Short Ultrashort S&P500 (SDS)
SDS offers twice-daily leveraged downside exposure to the S&P 500 index. This ETF is designed for traders with a bearish short-term view on large-cap U.S. companies across sectors.
Fund issuer: ProShares
Expense ratio: 0.91 percent
Average daily volume: ~16 million shares
Assets under management: ~$609 million
Direxion Daily Semiconductor Bear 3x Shares (SOXS)
SOXS provides three times daily leveraged downside exposure to an index of companies involved in developing and manufacturing semiconductors. This ETF is designed for traders with a bearish short-term outlook on the semiconductor industry.
Fund issuer: Rafferty Asset Management
Expense ratio: 1.11 percent
Average daily volume: ~8.2 million shares
Assets under management: ~$126 million
Direxion Daily Small Cap Bear 3X Shares (TZA)
TZA provides three times daily leveraged downside exposure to the small-cap Russell 2000 index. This ETF is designed for traders with a bearish short-term outlook on the US economy.
Fund issuer: Rafferty Asset Management
Expense ratio: 1.10 percent
Average daily volume: ~8.2 million shares
Assets under management: ~$357 million
ProShares UltraShort 20+ Year Treasury (TBT)
TBT offers twice-daily leveraged downside exposure to the Barclays Capital U.S. 20+ Year Treasury Index. This ETF is designed for traders who want to make a leveraged bet on rising interest rates.
Fund issuer: ProShares
Expense ratio: 0.92 percent
Average daily volume: ~3.9 million shares
Assets under management: ~$1.5 billion
What is short selling?
Short selling is an investment strategy used by traders to speculate on the price decline of an asset.
In short selling, traders borrow an asset so they can sell it to other market participants. The objective is to buy back the asset at a lower price, return it to the original lender, and pocket the difference. However, when the asset price increases, traders are on the hook to buy it back at a higher price.
Short selling is a risky strategy because the price of an asset can essentially rise to infinity.
For example, if you buy a company’s stock for $10 and the company declares bankruptcy, your potential loss is $10. However, if you short the same stock, and the company gets acquired, causing the shares to jump to $300, your potential loss is exponentially bigger as you are obligated to buy back the stock and return it to the lender.
The concept of short selling gained notoriety earlier this year when shares of GameStop (GME) jumped from around $40 to nearly $400 in a few days as short sellers were forced out of their positions.
What is leveraged short selling?
Leveraged short-selling lets traders use debt to increase their buying power. With the additional funds, traders often purchase futures and other financial derivatives to speculate on the stock or bond markets.
By taking additional risk, traders seek to capture outsized returns.
Leveraged trading is also known as margin trading. The strategy can be risky because those bets often become outsized losses when a trade goes sour. Plus, traders need to pay back the borrowed funds along with any transaction fees.
Apart from these factors, traders have to pay short-term capital gains taxes, primarily if the assets are in a taxable account. In addition, multiple fees are associated with trading on margin and short selling.
How traders use leveraged short ETFs
With leveraged short ETFs, traders aim to magnify investment returns. Think of leveraged ETFs as ETFs on steroids.
For example, the ProShares UltraPro Short QQQ ETF (SQQQ) uses swaps and futures to provide three times the inverse daily performance of the Nasdaq 100 index. So, conceptually, if the Nasdaq 100 is down 1 percent, this short ETF could be up 3 percent. It all depends on the type of leverage used and how it connects to the news causing the move.
While that might sound tempting, potential losses can be just as pronounced. Financial derivatives, like other exotic market products, react differently to negative news. Using the hypothetical example above, when the Nasdaq jumps 2 percent, a leveraged short ETF could plunge around 6 percent, depending on the underlying assets used.
How to buy inverse/short ETFs
There are plenty of ETF screening tools, including those provided by most brokerage firms. While factors like management fees and daily trading performance are important considerations, you should thoroughly review the fund’s prospectus.
As you narrow your options, the key features to consider are:
Leverage: This metric is qualified by a numeral followed by the letter “x.” So, a fund like the Direxion Daily S&P 500 Bull 3X Shares (SPXL) offers three times the performance of the S&P 500 index. In addition, the leveraged expected return is for a single day, not cumulative over time.
Expense ratios and fees: Compared to traditional funds, short ETFs carry higher fees. Keep in mind that those costs can add up, so make sure to compare apples to apples and read the fine print.
Trading volume: The more liquid a fund is, the easier it will be to buy and sell. Look at how average trading volume compares to similar ETFs.
Fund performance: Numbers don’t lie. While doing your research, take a look at a fund’s daily performance. But remember, these funds are not intended as a buy-and-hold strategy.
Assets under management (AUM): Many investors use this figure as a vote of confidence to assess other investors’ engagement with a particular ETF. Along with AUM figures, it might be helpful to check the longevity of the fund.
Fund issuer: Brands are powerful. And that’s no different in the ETF space. Some investors feel comfortable investing only with large asset managers, while others see the value in newcomers. Decide what works for you and your financial needs.
Use these criteria as a starting point to do more research. For example, some traders find it helpful to study the daily performance of inverse/short ETFs before committing any money.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
What to Know Before Buying Inverse and Short ETFs
Investors often use inverse exchange-traded funds (ETFs) in advanced trading strategies, but they can help hedge any investor's downside risk or help open a bearish position in a commodity or sector. Due to their more complex nature, you should learn all you can about these types of funds, also known as short ETFs, before you add any to your current portfolio.
What Is an Inverse ETF?
An inverse ETF is an index ETF that gains value when its correlating index loses value. It achieves this by holding assets and derivatives, like options, that are used to create profits when the underlying index falls. The Short DOW 30 ETF (DOG) profits when the Dow Jones Industrial Average goes down. The DOG's profits are proportional to the Dow's losses.
Inverse ETFs are risky assets that you should approach with caution. That said, there are a few ways in which investors can benefit from using them.
Investors with a risky amount of exposure to a certain index, sector, or region can buy an inverse ETF to help hedge that exposure. They can use inverse ETFs in their investing strategy to gain downside exposure in the market. Buying into an inverse ETF can be a less risky way to make that bearish bet if your research has led you to take a bearish stance on an index or sector.
Advantages of Inverse ETFs
Inverse ETFs enjoy many of the same benefits as a standard ETF, including ease of use, lower fees, and tax advantages.
The benefits of inverse ETFs have to do with the alternative ways of placing bearish bets. Not everyone has a trading or brokerage account that allows them to short sell assets. These investors can instead purchase shares in an inverse ETF, which gives them the same investment position they would have by shorting an ETF or index.
Inverse ETFs are thought to be riskier than traditional ETFs, but they're bought outright. This makes them less risky than other forms of bearish bets. There's often unlimited risk when an investor shorts an asset. The investor could end up losing much more than they had anticipated.
An investor can only lose as much as they paid for the ETF with inverse ETFs.
The inverse ETF becomes worthless in a worst-case scenario, but at least you won't owe anyone money, as you might when you short an asset in a traditional sense.
Disadvantages of Inverse ETFs
One of the main risks of inverse ETFs is their lack of popularity. You can buy many types of ETFs, but you won't find a huge selection of inverse ETFs. You'll likely find that inverse ETFs have less liquidity than other ETFs due to fewer options and less demand.
Another risk is that major stock indexes have historically risen when the timescale is long enough. This makes it risky to use inverse ETFs as part of a buy-and-hold strategy. History suggests that the index will bounce back sooner or later from any losses in recent years. Inverse ETF investors need to keep a close eye on the markets. They can attempt to exit their position before the corresponding index rallies.
Funds to Think About
Give some thought to the following inverse index ETFs if you want to hedge some portfolio risk or have a bearish feeling about a certain market index: Short S&P 500 (SH) inversely tracks the S&P 500 Index. Short Russell 2000 (RWM) inversely tracks the Russell 2000 Index.
Watch some other inverse ETFs if you have risk in a certain market sector or have a negative feeling about a certain industry: UltraShort Financials (SKF) inversely tracks the Dow Jones U.S. Financial Index. UltraShort Industrials (SIJ) inversely tracks the Dow Jones U.S. Industrials Index. UltraShort Real Estate (SRS) inversely tracks the Dow Jones U.S. Real Estate Index.
You can even invest in inverse ETFs for certain country and region indexes. UltraShort MSCI Japan (EWV) inversely tracks the MSCI Japan Index. UltraShort FTSE China 50 (FXP) inversely tracks the FTSE China 50 Index.
The Bottom Line
Inverse ETFs can be a powerful tool in your investing strategy, but make sure you perform due diligence before you make any trades. Think about both the pros and the cons. Watch the performance of some inverse ETFs before you get started.
Consult a financial professional or your broker to answer any questions or concerns you may have. Your research and due diligence are the key commodities in the world of ETF investing.
NOTE: The Balance doesn't provide tax or investment services or advice. This information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any one investor. It might not be right for all investors. Investing involves risk, including the loss of principal.
Part III: The Efficacy of Hedging with Inverse ETFs
◀ Return to Portfolio Hedging
In Part I: The Significance of Portfolio Hedging, we talked about the inevitability of market downturns and ways to help dampen their effects. In Part II: Strategies for Hedging Your Portfolio, we discussed hedging with inverse exposure, in particular, with inverse ETFs. So, do inverse ETFs work?
Here, we provide you with two case studies that illustrate the potential effectiveness of using ProShares inverse ETFs to hedge different asset classes under different market conditions. Remember that ProShares inverse ETFs have one-day investment objectives. While they may be held for periods longer than one day, you should monitor your investments as frequently as daily and consider a rebalancing strategy.
Hedging with ProShares Inverse ETFs
ProShares inverse ETFs are frequently used to hedge equity and bond holdings. And, as investors have diversified into a broader selection of asset classes, it has become common to see investors hedging commodity and currency holdings as well. Let's examine case studies with ProShares ETFs used to hedge these types of assets. In all instances, a rebalancing strategy based on a 10% trigger was used—trigger-based rebalancing is explained in Part II: Strategies for Hedging Your Portfolio.
It is probably safe to say that most of us have large-cap investments in our portfolios. The S&P 500 is one of the largest and most widely followed indexes in the world. The ProShares Short S&P 500 ETF (ticker: SH) offers daily inverse (-1x) exposure to the S&P 500. If the S&P 500 falls 1% on a day, SH is designed to rise by 1%, and vice versa. Let's look at an example of a hedge using SH during an extreme market disruption: the first three months of 2020 as the unfolding COVID-19 crisis sent stocks into freefall.
|S&P 500 with 10% Hedge in SH (-1x ETF)||-16.17%||44.86%|
|S&P 500 with 20% Hedge in SH (-1x ETF)||-13.30%||35.49%|
Source: Bloomberg. The illustration used a 10% rebalance trigger. Illustration shows NAV returns. Market price returns, which more closely reflect the experience of an investor, may yield different results. The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor's shares, when sold or redeemed, may be worth more or less than the original cost. Shares are bought and sold at market price (not NAV) and are not individually redeemed from the fund. Market price returns are based upon the midpoint of the bid/ask spread at 4:00 p.m. ET (when NAV is normally determined for most funds) and do not represent the returns you would receive if you traded shares at other times. Brokerage commissions will reduce returns. For both standardized performance and return data current to the most recent month end, see Performance. Index returns are for illustrative purposes only and do not represent fund performance. Index returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest in an index.
As illustrated, the S&P 500 declined nearly 20% during the period and volatility spiked to 57%. Many of us are painfully aware that investors who were overly reliant on traditional diversification to control risk during that period lost significant amounts of money. Had investors been hedging their large-cap investments with SH, they could have seen reduced losses and improved volatility.
With just a 10% hedge position in SH, returns could have been improved by over 3% and volatility reduced by 12%. A 20% hedge, as expected, could have had nearly double the impact. Potential returns could have been improved by over 6% and volatility reduced by over 21%.
Many investors hold long-term Treasuries or Treasury bonds as part of the fixed income allocation in their portfolio. To hedge a bond investment against rising interest rates, for example, an inverse ETF like the ProShares Short 20+ Year Treasury ETF (ticker: TBF) is often used. It is designed to seek daily inverse (-1x) exposure to the ICE U.S. Treasury 20+ Year Bond Index.
In this example, we compare the ICE U.S. Treasury 20+ Year Bond Index (the “20+ Year Treasury Index”), a measure of bond market performance, with 10% and 20% hedge positions in TBF. Treasury yields in the United States have largely declined over the past four decades, and more recently, the Federal Funds Rate was reduced to near zero. The 10- and 30-Year U.S. Treasury yields hit new lows in 2020 amid the fallout from COVID-19. From the end of July to the end of October, intermediate and longer-term Treasury yields moved higher, receiving a boost from stimulus packages and expectations of improved growth and inflation prospects. Rates and yields move in the opposite direction from bond prices, so when rates and yields rise, bond prices decline.
|ICE U.S. Treasury 20+ Year||-7.04%||11.86%|
|ICE U.S. Treasury 20+ Year with 10% Hedge in TBF (-1x ETF)||-5.76%||9.64%|
|ICE U.S. Treasury 20+ Year with 20% Hedge in TBF (-1x ETF)||-4.70%||7.81%|
Source: Bloomberg. The illustration, using a 10% trigger, would have required two rebalances. Illustration shows NAV returns. Market price returns, which more closely reflect the experience of an investor, may yield different results. The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor's shares, when sold or redeemed, may be worth more or less than the original cost. Shares are bought and sold at market price (not NAV) and are not individually redeemed from the fund. Market price returns are based upon the midpoint of the bid/ask spread at 4:00 p.m. ET (when NAV is normally determined for most funds) and do not represent the returns you would receive if you traded shares at other times. Brokerage commissions will reduce returns. For both standardized performance and return data current to the most recent month end, see Performance. Index returns are for illustrative purposes only and do not represent fund performance. Index returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest in an index.
If you look at returns for the 20+ Year Treasury Index, yields increased between July 31 and October 30, 2020, you'll see that returns fell over 7% with volatility nearing 12%. Even a 10% hedge would have reduced losses from 7.0% to approximately 5.8% and also reduced volatility. A larger 20% hedge could have cut losses to less than 5% and reduced volatility below 8%.
Something else to keep in mind when hedging bonds is duration—a measure of a bond's price sensitivity to changes in interest rates. In this case, the 20+ Year Treasury Index has a modified duration of 19, making TBF's duration -19 as well. You should also be aware of how your fixed income exposure is spread across the points on the yield curve, as well as which points you want to hedge. ProShares offers a suite of inverse Treasury funds that invest in bonds with a range of maturities up to 20+ years.
ProShares has been at the forefront of the ETF revolution since 2006. ProShares now offers one of the largest lineups of ETFs, with more than $54 billion in assets1. The company is the leader in strategies such as dividend growth, interest rate hedged bond and geared (leveraged and inverse) ETF investing. ProShares continues to innovate with products that provide strategic and tactical opportunities for investors to manage risk and enhance returns.
With over 60 inverse ETFs available across a range of sectors and asset classes, ProShares can help you execute an array of potential hedging strategies. Contact your tactical consultant for more information.
| Broad Market |
|Dow Jones Industrial Average||SDOW||DXD||DOG|
|S&P MidCap 400||SMDD||MZZ||MYY|
|S&P SmallCap 600||--||SDD||SBB|
| Sector |
|Dow Jones U.S. Basic Materials||--||SMN||SBM|
|S&P Communication Services Select Sector||--||YCOM||--|
|Dow Jones U.S. Consumer Goods||--||SZK||--|
|Dow Jones U.S. Consumer Services||--||SCC||--|
|Dow Jones U.S. Financials||--||SKF||SEF|
|Dow Jones U.S. Health Care||--||RXD||--|
|Dow Jones U.S. Industrials||--||SIJ||--|
|Dow Jones U.S. Oil & Gas||--||DUG||DDG|
|Dow Jones U.S. Real Estate||--||SRS||REK|
|Solactive-ProShares Bricks and Mortar Retail Store||--||--||EMTY|
|Dow Jones U.S. Semiconductors||--||SSG||--|
|Dow Jones U.S. Technology||--||REW||--|
|Dow Jones U.S. Select Telecommunications||--||--||--|
|Dow Jones U.S. Utilities||--||SDP||--|
| International |
|MSCI Emerging Markets||--||EEV||EUM|
|FTSE Developed Europe All Cap||--||EPV||--|
|MSCI Brazil 25/50 Capped||--||BZQ||--|
|FTSE China 50||--||FXP||YXI|
| Fixed Income |
|ICE U.S. Treasury 20+ Year Bond||TTT||TBT||TBF|
|ICE U.S. Treasury 7-10 Year Bond||--||PST||TBX|
|Markit iBoxx $ Liquid High Yield||--||--||SJB|
| Commodity |
|Bloomberg WTI Crude Oil Subindex||--||SCO||--|
|Bloomberg Natural Gas Subindex||--||KOLD||--|
|Bloomberg Gold Subindex||--||GLL||--|
|Bloomberg Silver Subindex||--||ZSL||--|
| Currency |
|EUR/USD 4:00 p.m. ET exchange rate||--||EUO||EUFX|
|AUD/USD 4:00 p.m. ET exchange rate||--||CROC||--|
|JPY/USD 4:00 p.m. ET exchange rate||--||YCS||--|
The Risks of Investing in Inverse ETFs
Inverse exchange-traded funds (ETFs) seek to deliver inverse returns of underlying indexes. To achieve their investment results, inverse ETFs generally use derivative securities, such as swap agreements, forwards, futures contracts, and options. Inverse ETFs are designed for speculative traders and investors seeking tactical day trades against their respective underlying indexes.
Inverse ETFs only seek investment results that are the inverse of their benchmarks' performances for one day only. For example, assume an inverse ETF seeks to track the inverse performance of Standard & Poor's 500 Index. Therefore, if the S&P 500 Index increases by 1%, the ETF should theoretically decrease by 1%, and the opposite is true.
- Inverse ETFs allow investors to profit from a falling market without having to short any securities.
- Inverse ETFs are designed for speculative traders and investors seeking tactical day trades against their respective underlying indexes.
- For example, an inverse ETF that tracks the inverse performance of the Standard & Poor's 500 Index would reflect a loss of 1% for every 1% gain of the index.
- Because of how they are constructed, inverse ETFs carry unique risks that investors should be aware of before participating in them.
- The principal risks associated with investing in inverse ETFs include compounding risk, derivative securities risk, correlation risk, and short sale exposure risk.
Compounding risk is one of the main types of risks affecting inverse ETFs. Inverse ETFs held for periods longer than one day are affected by compounding returns. Since an inverse ETF has a single-day investment objective of providing investment results that are one times the inverse of its underlying index, the fund's performance likely differs from its investment objective for periods greater than one day.
Investors who wish to hold inverse ETFs for periods exceeding one day must actively manage and rebalance their positions to mitigate compounding risk.
For example, the ProShares Short S&P 500 (SH) is an inverse ETF that seeks to provide daily investment results, before fees and expenses, corresponding to the inverse, or -1X, of the daily performance of the S&P 500 Index. The effects of compounding returns cause SH's returns to differ from -1X those of the S&P 500 Index.
As of May 31, 2021, based on trailing 12-month data, SH had a net asset value (NAV) total return of -11.46%, while the S&P 500 Index had a return of over 35%.
The effect of compounding returns becomes more conspicuous during periods of high market turbulence. During periods of high volatility, the effects of compounding returns cause an inverse ETF's investment results for periods longer than one single day to substantially vary from one times the inverse of the underlying index's return.
For example, hypothetically assume the S&P 500 Index is at 1,950 and a speculative investor purchases SH at $20. The index closes 1% higher at 1,969.50 and SH closes at $19.80. However, the following day, the index closes down 3%, at 1,910.42. Consequently, SH closes 3% higher, at $20.39. On the third day, the S&P 500 Index falls by 5% to 1,814.90, and SH rises by 5% to $21.41. Due to this high volatility, the compounding effects are evident. The index fell by 9.3%. However, SH increased by 7.1%.
Inverse ETFs carry many risks and are not suitable for risk-averse investors. This type of ETF is best suited for sophisticated, highly risk-tolerant investors who are comfortable with taking on the risks inherent to inverse ETFs.
Derivative Securities Risk
Many inverse ETFs provide exposure by employing derivatives. Derivative securities are considered aggressive investments and expose inverse ETFs to more risks, such as correlation risk, credit risk, and liquidity risk. Swaps are contracts in which one party exchanges cash flows of a predetermined financial instrument for cash flows of a counterparty's financial instrument for a specified period.
Swaps on indexes and ETFs are designed to track the performances of their underlying indexes or securities. The performance of an ETF may not perfectly track the inverse performance of the index due to expense ratios and other factors, such as the negative effects of rolling futures contracts. Therefore, inverse ETFs that use swaps on ETFs usually carry greater correlation risk and may not achieve high degrees of correlation with their underlying indexes compared to funds that only employ index swaps.
Additionally, inverse ETFs using swap agreements are subject to credit risk. A counterparty may be unwilling or unable to meet its obligations and, therefore, the value of swap agreements with the counterparty may decline by a substantial amount. Derivative securities tend to carry liquidity risk, and inverse funds holding derivative securities may not be able to buy or sell their holdings in a timely manner, or they may not be able to sell their holdings at a reasonable price.
Inverse ETFs are also subject to correlation risk, which may be caused by many factors, such as high fees, transaction costs, expenses, illiquidity, and investing methodologies. Although inverse ETFs seek to provide a high degree of negative correlation to their underlying indexes, these ETFs usually rebalance their portfolios daily, which leads to higher expenses and transaction costs incurred when adjusting the portfolio.
Moreover, reconstitution and index rebalancing events may cause inverse funds to be underexposed or overexposed to their benchmarks. These factors may decrease the inverse correlation between an inverse ETF and its underlying index on or around the day of these events.
Futures contracts are exchange-traded derivatives that have a predetermined delivery date of a specified quantity of a certain underlying security, or they may settle for cash on a predetermined date. With respect to inverse ETFs using futures contracts, during times of backwardation, funds roll their positions into less expensive, further-dated futures contracts. Conversely, in contango markets, funds roll their positions into more expensive, further-dated futures.
Due to the effects of negative and positive roll yields, it is unlikely for inverse ETFs invested in futures contracts to maintain perfectly negative correlations to their underlying indexes on a daily basis.
Short Sale Exposure Risk
Inverse ETFs may seek short exposure through the use of derivative securities, such as swaps and futures contracts, which may cause these funds to be exposed to risks associated with short-selling securities. An increase in the overall level of volatility and a decrease in the level of liquidity of the underlying securities of short positions are the two major risks of short-selling derivative securities. These risks may lower short-selling funds' returns, resulting in a loss.
Trade how etf to inverse
Inverse ETF Strategies
By: Eric Bank, MBA, MS Finance
A rising stock market tends to make investors nervously watch for the first sign of a steep sell-off. Other investors prefer to profit from a falling market. Both groups can benefit from inverse exchange-traded funds, or ETFs, which move in the opposite direction from their underlying assets -- stocks, bonds, currencies or commodities. Hedgers use inverse ETFs to lower the risk of loss, while speculators employ strategies to produce profits from a market crash. When knowledgeably used, inverse ETFs can reduce your risk and increase your return.
Exchange Traded Funds
ETFs are baskets of stocks or other assets that are tied to a particular index. For example, several ETFs are linked to the S&P 500 Index. ETFs offer instant diversification just as mutual funds do, but they are bought and sold in real time on the stock exchange like any other stock. You can trade ETFs through a normal brokerage account. They trade throughout the day, whereas mutual funds allow you to purchase or redeem shares only after the market closes for the day.
Inverse ETFs move in the opposite direction from their underlying indexes. An inverse ETF on the S&P 500 would use techniques like shorting and derivatives trading to achieve the desired outcome. Shorting involves borrowing and selling shares that will be repurchased later -- ideally, at a lower price -- and returned to the lending broker. Derivatives like options and futures contracts can be traded to benefit from a price decline in the underlying asset. Managers of inverse ETFs attempt to give their funds the same volatility as the underlying assets, but in the opposite direction.
Ultra-inverse ETFs use leverage, or debt, techniques to produce double or triple the inverse results of the underlying asset. This includes the use of margin buying in which most of an asset position is financed with debt. Highly leveraged instruments like futures and options are extensively used. These techniques are employed in vehicles such as the ProShares UltraPro Short -3x funds, which give triple inverse returns on stock, bond, currency or commodity indexes. Leveraging allows speculators and hedgers to achieve magnified results relative to the size of their investments, but it also can be quite risky if prices move in the wrong direction.
Speculators use inverse ETFs to profit from downswings in asset prices. These investors are often referred to as “bears”; in the past, they had to perform all the work themselves, including shorting stocks, selling futures and buying put options. Inverse ETFs simplify bearish investing by allowing the fund manager to offer an easily traded product with predictable performance. Buyers of inverse ETF shares can set up protective sell instructions in the event that prices move against them, thus limiting their potential losses to a predetermined amount. They can also lock in gains by employing rising stops; these ratchet up the price that triggers a sell instruction as the value of the inverse ETF increases.
Hedgers are seeking to protect a purchased, or “long,” position in stocks, bonds or other assets without selling off the assets. Hedgers can establish a counter-position with an inverse ETF and then strategically manage the position as prices change. For instance, if prices rise and your long position gains $5,000 in value, you can sell off that amount and use the money to purchase additional inverse ETF shares. You can do the reverse if prices fall. This type of hedging ensures that you are always hedged to a sufficient extent to avoid large losses.
- The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy; David Wiedemer et al.
- Trading ETFs: Gaining an Edge With Technical Analysis; Deron Wagner, Alan Farley
- Jim Cramer's Getting Back to Even; James J. Cramer, Cliff Mason
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.
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