Inverse ETF Strategies

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

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.

Leverage

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.

Speculation Strategy

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.

Hedge Strategy

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.

Resources (3)

  • 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

Photo Credits

  • Creatas Images/Creatas/Getty Images

About the Author

Based in Chicago, Eric Bank has been writing business-related articles since 1985, and science articles since 2010. His articles have appeared in "PC Magazine" and on numerous websites. He holds a B.S. in biology and an M.B.A. from New York University. He also holds an M.S. in finance from DePaul University.

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