Bearish markets can make inverse ETF strategies attractive to experienced traders looking for a short-term trade to attempt to capitalize on market downswings — without the hassle and risk of selling short, requiring a margin account or risking unlimited losses.
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?
The basic concept behind inverse ETFs is fairly simple. When the underlying target index goes down, the value of the inverse ETF is designed to go up. The target index may be broad-based, like the S&P 500, or it could be a basket chosen to follow a specific area of the economy, such as the financial sector.
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?
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. That’s the basic idea behind an inverse ETF, but the actual trades are more complex.
For instance, say 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 hope the value of the index decreases, so the value of your ETF increases. That same day, the index falls 10% and closes at 9,000. As a result, your share increases 10% to $110.
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?
Inverse ETFs are intended for intraday trading — not longer. Although they can seem simple, inverse ETFs require considerable skill since they rebalance daily. In other words, all price movements are calculated on a percentage basis for that day and that day only – calculations restart the next day.
Daily rebalancing can throw a monkey wrench into expected profit and loss calculations and cause worse-than-expected returns.
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:
1. Actively manage intraday trades
Since inverse ETFs are designed for intraday trading, keep a tight leash on this strategy. Don’t run an inverse ETF on a day when you’re unable to pay full attention — that is, when you may not have internet access, need to run errands or have other obligations that divert attention away from the trade.
Instead, watch price movements carefully throughout the day. Stay tuned to your favorite financial channel and on top of news reports. Keep your trading screen up with a finger on the trigger, ready to get in or out at a moment’s notice.
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.
2. Set realistic expectations due to increased costs
Be prepared for an increased number of hurdles when you’re trying to post gains. As an intraday play, an inverse ETF gives you 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. Considering the difficulty of estimating the market’s direction and possible taxes on gains, you should only enter this trade with a clear goal. Once you’ve met it, don’t get greedy — get out.
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.
3. Expect market volatility
Because this strategy typically runs intraday, you can expect volatility in the market. You can be spot on with your bearish sentiment, but if the market moves only a little, you might not make enough profit to cover commissions and the bid-ask spread — or make running this strategy worth your time and effort.
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
Inverse ETFs aren’t intended for long-term bearish movements or for hedging your portfolio against longer-term downswings because of the disadvantage of daily rebalancing.
If you’re looking for a strategy to capitalize on long-term bearish movement, you could consider strategies like short common stock or short index ETF. Just be sure you understand the risk of potentially unlimited losses when running these strategies.
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).