The concept behind inverse exchange-traded funds or ETFs seems quite simple. When the underlying target index goes down, the value of the ETF is designed to go up. The target index may be broad-based, like the Standard & Poor’s 500 index, or it could be a basket chosen to follow a specific area of the economy, such as the financial sector.
For example, if an index ETF based on the S&P 500 increases in price by $1, an inverse ETF based on the S&P 500 would likely decrease by $1. Conversely, if an ETF based on the financial sector decreases in price by $1, an inverse financial sector ETF would likely increase by $1. This play should not be confused with short index ETF.
Inverse ETFs are a way to capitalize on intra-day bearish movements. Many investors actively trade ETFs because they think they are better able to estimate the overall direction of the market or a sector, instead of trying to do the same for an individual stock, which is more subject to unexpected news events.
Regardless of your expectations, the market can always behave counter to what you intend. Owning an inverse ETF can result in losses if the ETF’s target index rises in value. The sharper the increase, the greater the loss will be.
If you’re an experienced trader who’s looking for a short-term trade to capitalize on market downswings, this might seem like a pretty attractive trade. After all, you won’t have to deal with all the hassles and risks selling short entails – like maintaining a margin account or worrying about unlimited losses. As a result, some novice traders may be tempted to jump into this strategy without understanding what they’re really getting into, which can be a big mistake. A critical fact, overlooked by rookies and veteran traders alike, is this strategy is intended as an intra-day trade. Bear in mind: the more frequently you trade, the more transaction costs you will incur.
Inverse ETFs aren’t designed to be held overnight
Although it seems pretty simple at first glance, this is actually a tricky trade that requires considerable skill because inverse ETFs rebalance daily. In other words, all price movements are calculated on a percentage basis for that day and that day only. The next day you start all over from scratch.
Here’s an example of beta slippage or how daily rebalancing can throw a monkey wrench into your expected profit and loss calculations and cause worse-than-expected returns.Imagine you pay $100 for one share of an inverse ETF based on an index that’s currently at 10,000. Since you’ve bought an inverse ETF, you’re hoping the value of the index goes down so your ETF goes up in value. That same day, the index falls 10% and closes at 9,000. As a result, your share will increase 10% to $110.
Here’s the catch: daily rebalancing means the next day you start over from scratch. If the index opens at 9,000 and then makes a bullish move, closing at 10,000, that’s an increase of 11.11%. Your inverse ETF will decrease in value by that same percentage, and as a result, your share will go down from $110 to $97.78 (11% of $110 is $12.221).
Failure to understand how daily rebalancing affects inverse ETFs can wreak havoc on traders who try to hold them over longer periods of time. Although Ally Invest doesn’t promote day trading, inverse ETFs are intended as an intra-day trade. Trading on a daily basis can lead to more transaction costs.
If you decide to hold a position in an inverse ETF for longer than one day, at a minimum you should monitor your holdings daily. You must realize if you hold an inverse ETF over multiple trading sessions, one reversal day could not just obliterate any gains you’ve racked up, you could find yourself suddenly (and unexpectedly) facing a loss.
Don’t get creative
Using these complex ETFs for any reason other than their primary purpose is strongly ill-advised. Here are some scenarios you might have erroneously considered, paired with appropriate alternatives.
If you’re looking for a strategy to capitalize on more long-term bearish movement, you may want to consider strategies like short common stock or short index ETF. Be sure you understand the risk of potentially unlimited losses when running these strategies.
Leave trading options on inverse ETFs to the pros. These ETFs are already more complex than the average trade because of their opposite movement, daily rebalancing and the risk of beta slippage. Layer options on top of that, and you have even more moving parts to worry about.If you understand the risks and want downside exposure over a longer period, you can trade bearish options positions on a traditional ETF, like an index ETF or a sector ETF.
Don’t use inverse ETFs to hedge your portfolio against a longer-term downswing in the markets. This is a mistake because of the disadvantage of daily rebalancing. If you’re looking to hedge your portfolio and you understand the risks, you might want to look into applying the Protective Put Strategy .
Set realistic expectations due to increased costs
Because you’ll generally be trading inverse ETFs as an intra-day trade, you must be prepared for the increased number of hurdles you face when trying to post gains. You have a very limited time frame to cover all your expenses, namely two commissions (one to enter and one to exit the position), plus the gap between the bid and offer prices on each trade. Add in the difficulty of estimating the market’s direction and any possible taxes on gains, and you have your work cut out for you. Only enter this trade with a clear goal, and don’t get greedy once you’ve met it.Please note: If you use an inverse ETF in a market timing strategy, this may involve frequent trading, higher transaction costs, and the possibility of increased capital gains that will generally be taxable to you as ordinary income. Market timing is an inexact science and a complex investment strategy.
Any time you enter a trade, you are obviously expecting the results to be outstanding. But as you know that will not always be the case. Even the most carefully chosen inverse ETF position can result in losses if the target index increases in value.
You need to keep a very tight leash on this strategy. Don’t run it on a day when you may not have internet access for an extended period of time. Don’t run errands during the trading session. Avoid long walks in the woods or on the beach if you’re not carrying your smartphone with a signal-boosting case.
You must watch price movements very carefully throughout the day, stay tuned to your favorite financial channel, and keep on top of potential news reports. Keep your trading screen up with your finger on the trigger, ready to get in or out at a moment’s notice. Remember: agility is the name of the game with this strategy.
Ally Invest Margin Requirements
If you understand the risks, long inverse ETFs can be purchased on margin as long as you have a margin account which meets the minimum equity requirement of $2,000. While the initial margin requirement in general is 50% for many leveraged ETFs we have a higher house requirement up to 100%. No funds would be able to be borrowed if the leveraged ETF has a 100% margin requirement. These requirements can change due to market volatility, fluctuations in the ETF’s value, concentrated positions, trading illiquid or low-priced securities and other factors. Margin trading involves risks and is not suitable for all accounts.
Because this strategy will typically be run as an intra-day trade, you need to expect some volatility in the market. Even if you’re right about your bearish sentiment, if the market only moves a little you might not make enough profit to cover commissions and the bid-ask spread, much less make running this strategy worth your time and effort.
On the other hand, don’t let that volatility work against you. Beware of strong bullish movements and reversals in the market—even when the early trading is working in your favor.Although it is possible that an ETF may have lesser volatility than another investment, it does not mean it is low risk.
If there is a known news event coming up during the trading session, it could cause the market to move in either direction. Some traders like a 15-minute buffer before news is released, and get out in advance. Others prefer to stay in the trade because they are willing to deal with the increased risk of volatility. Either way, be sure you are making an active decision to stay in or out during an anticipated news release.
Since this tends to be a short-term trade, you need to be able to get in and out easily. Try to stick to more liquid inverse ETFs. That way you’ll be able to find a buyer when you need to get out, and you’ll face a smaller bid-ask spread. As a general rule, consider sticking to ETFs with average daily volume of at least 2 million shares. Regardless of how liquid it may be, any security is still subject to periods of increased price fluctuation and may experience gaps in price.
Because this play is best run as an intra-day trade, the order flow at the end of the day may tend to be very one-sided. That is, far more people will be looking to sell than to buy inverse ETFs. As a result, the bid price may be lower than you’d expect (or the quote wider than you’d expect) and your fill price may be adversely affected. Consider closing your trade earlier in the day (if possible) as soon as you’ve met your goals.
Don’t get greedy and wait for the last minute before the market closes. Consider giving yourself at least 15-30 minutes before the closing bell. You’ll need to balance the risk of heading off lop-sided order flow with getting out early and missing a potential opportunity.