What we'll cover
What an inverse ETF is and how it works
How long to hold inverse ETFs
Advantages and disadvantages of inverse ETFs
Read on to learn more about the risks and advantages of inverse ETFs, how they work and how long to hold them.
What is an inverse ETF?
An inverse ETF is an exchange-traded fund designed to capitalize on intraday bearish movements in the markets. That is, it’s traded on the stock market, designed to perform the inverse of the index it tracks.
How does an inverse ETF work?
Many investors actively trade ETFs to help them better navigate the market or a sector, but often overlook three facts about inverse ETFs:
An inverse ETF is intended for intraday trading
The more frequently you trade intraday, the more transaction costs you incur
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
What is an example of an inverse ETF?
With daily rebalancing, calculations restart the next day. If the index opens at 9,000, for instance, 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. As a result, your share decreases from $110 to $97.78 (11% of $110 is $12.22).
How long should you hold inverse ETFs?
Not understanding how daily rebalancing affects inverse ETFs can wreak havoc on traders who hold them over longer periods. If you do choose to hold an inverse ETF position for longer than one day, monitor your holdings daily, at least. One reversal day could obliterate any gains you’ve made, and you could find yourself suddenly (and unexpectedly) facing a loss.
Advantages of inverse ETFs
For those who understand them, inverse ETFs hold three main advantages. They:
Offer experienced investors the possibility of making money when the market or the underlying index declines
Have the potential to help investors hedge their portfolio
Are available for a variety of market indexes
Disadvantages of inverse ETFs
Inverse ETFs also come with significant disadvantages for those who don’t understand how they work. Specifically, they can result in losses and higher fees if investors:
Wager inaccurately on the market's direction
Hold them for more than one day
Trade too frequently throughout the day
Inverse ETF strategies
Three strategies can help investors manage inverse ETFs:
Agility is key with this strategy, and keeping an eye on the underlying index is critical. Even the most carefully chosen inverse ETF position can result in losses if the target index increases in value.
What’s more, using an inverse ETF in a market timing strategy could involve frequent trading, higher transaction costs and the possibility of increased capital gains that are generally taxable as ordinary income. Timing the market is an inexact science and a complex investment strategy.
On the other hand, don’t let volatility work against you. Beware of strong bullish movements and reversals in the market, even when early trading is working in your favor. Although it’s possible that an ETF may have lesser volatility than another investment, it’s not necessarily low risk. Using these complex ETFs for any reason other than their intended purpose can be disastrous.
When not to use inverse ETFs
Or, if you’re looking to hedge your portfolio — and you understand the risks — you might consider applying a protective put strategy.
3 key takeaways on inverse ETFs
Inverse ETF strategies can be attractive to experienced traders who bear these things in mind:
Inverse ETFs are susceptible to market changes, especially news events that could cause the market to move in either direction.
Since inverse ETFs are designed as short-term trades, you must be able to get in and out easily. Stick with more liquid inverse ETFs to help you find a buyer when you need to get out with a smaller bid-ask spread.
Consider closing your trade earlier in the day or as soon as you’ve met your goals. Because this play is best run as an intraday trade, far more people will look to sell rather than buy inverse ETFs, making the bid price lower than you’d expect (or the quote wider than you’d expect).
