In rough markets, the ability to go short or long either 200% or 300% of an index’s daily value can prove to be a useful trading tool. But these types of funds should be used with caution, as with any investment, since they amplify market movements. In these times of higher volatility, that means big swings one way or the other than can catch an investor off guard if they aren’t paying attention.

It seems like for most of this year, long and short funds have been perched at the top in terms of daily performance. They can also give a quick snapshot of what sectors are feeling pain and how the markets are doing in general. Seeing a cluster of shorts sitting at the top of a list of funds ranked by daily, weekly or monthly returns tells you that the markets are hurting right now.

For the last five trading days, among the funds at the top are:

• Rydex Inverse 2x S&P Select Sector Financial (RFN)
• ProShares UltraShort Financials (SKF)
• ProShares UltraShort Real Estate (SRS)
• ProShares UltraShort SmallCap 600 (SDD)
• Rydex Inverse 2x Russell 2000 (RRZ)

Not all funds are right for every investor, so investors need to decide what is right and what works for them while using caution, and supplementing that with some education and research. If you think these funds might be right for you, do a gut check and make sure your risk profile fits.

We advocate sticking to a strategy of considering only those funds that are above their long-term trend lines (the 200-day moving average). Once they fall below that mark or 8% off the high, it’s time to let it go.

Read the disclosure, as Tom Lydon is a board member of Rydex Funds.

These types of funds are merely two years old, and the timing of their market debut was perfect.

ProFunds originated these funds back in 1997, when bear market index funds were created for investment professionals, reports Billy Fisher for TheStreet. The first short ETFs were launched in the summer of 2006, and those funds were:

• Short QQQ ProShares Fund (PSQ)
• Short S&P 500 ProShares Fund (SH)
• Short Dow 30 ProShares Fund (DOG)
• Short Midcap 400 ProShares Fund (MYY)

Since then, the number of not only these ETFs, but providers offering them and asset classes they cover, has expanded to include such funds as:

• PowerShares DB Agriculture Double Short (AGA)
• PowerShares DB Gold Short (DGZ)
  
• Rydex Inverse 2x Russell 2000 (RRZ)
• Rydex Inverse 2x S&P Select Sector Financial (RFN)
• Market Vectors Double Short Euro (DRR)

ETF investors no longer have to wait out on the sidelines while market turbulence dominates. Instead, they can benefit from both the ups and downs of markets while hedging their short-term risk. By subtracting the short-term risk, inverse ETFs have given investors the option to expand one’s holding period in a long position quite comfortably.

We caution investors, however, to be aware of the risks of these funds and to understand what they’re getting into. Because they can be especially susceptible to whipsaws in the marketplace, sticking to your sell strategy is key.

Read the disclosure, as Tom Lydon is a board member of Rydex Funds.

According to a report on “ETF Liquidity Trends” filed by Deutsche Bank on July 22, inverse (short) and leveraged ETFs generated the third- and sixth-highest turnover levels respectively.

Paul Amery of IndexUniverse notes that in this same report by Deutsche Bank, there were 18 leveraged and 18 inverse ETFs in Europe, which represents roughly 2% of the European ETF market. This lags behind U.S. numbers, in which there are 45 inverse and 31 leveraged ETFs, combining for more than 4% of the U.S. ETF market.

Despite the domestic ETF market being larger than that of the European market, inverse and leveraged ETFs in Europe are not yet as prevalent as those in the United States for a number of potential reasons. In Europe, for one, there’s a relative lack of interest on the part of retail investors.

Regardless of the development of the European leveraged and inverse ETF sector being slower than this sector here, it is an area which is host to dynamic product development and increasing demand. Some long and short ETFs include:

• UltraShort Financials ProShares (SKF), up 33.1% year-to-date
• Rydex Inverse 2x Russell 2000 (RRZ), up 11.1% year-to-date
• Rydex 2x S&P Select Sector Health Care (RHM), launched July 22
• UltraShort Basic Materials ProShares (SMN), down 13.2% year-to-date
• Ultra Financials ProShares (UYG), down 50% year-to-date

Read the disclosure, as Tom Lydon is a board member of Rydex Funds.

For instance, the ProShares Ultra Oil and Gas (DIG) beefed up more than 60% through June since its early 2007 inception, only to lose 30% in less than one month’s time as oil prices slipped, reports Chris Bain for Associated Press

These types of funds retain their popularity because of their ability to make investors money, even in a down market. Money has been pouring into these ETFs as they aim to profit by taking sizable bets on a sector or the broad market using leverage. “Ultra” ETFs made up 6 of the 20 most actively traded ETFs, and each touted a daily volume above 10 million shares.

The short and ultra short ETFs are for short term hedges, and are not recommended for long term bets. The ETFs, which use futures and swap agreements, are easy to trade and can protect a portfolio. It is a good way to provide insurance without actually having to go short. They are useful for investors who do not want to sell a losing position but want to protect against further declines.

These ETFs have been successful, but they are not for everyone. Use them with caution and know when to quit. Other short and ultra short ETFs:

• ProShares Ultra Short Financials (SKF), up 24.2% year-to-date
• ProShares Ultra Dow 30 (DDM), down 88% year-to-date
• Rydex Inverse Russell 2000 (RRZ), up 5.8% year-to-date
• Rydex 2x S&P 500 (RSU), down 27.6% year-to-date

Read the disclosure, as Tom Lydon is a board member of Rydex Funds.