After a tumultuous start to the new year, investors may be looking into inverse or bearish exchange traded fund options to hedge or even capitalize off market turns. However, traders should take the time to understand how the products work.
Inverse ETFs, like stocks, trade on an exchange, but unlike traditional beta-index ETFs, inverse options are designed to return the opposite return of a benchmark over a short-term horizon, writes Casey Murphy for Investopedia.
Excluding fees and costs associated with trading ETFs, an inverse ETF provides an easy way to short sell a specific market, or profit off falling prices.
For instance, the ProShares Short S&P 500 (NYSEArca: SH) takes a simple inverse or -100% daily performance of the S&P 500 index. While the S&P 500 index was up 0.4% Friday, SH dipped 0.4%. Over the past month, SH declined 3.2% while the S&P 500 rose 3.2%. As we can see, the inverse S&P 500 ETF mimics the opposite movement of the S&P 500 index over the short term. [Correction Prep With These Inverse ETFs]
While inverse ETFs lost out when the S&P 500 strengthened over the past month, investors still utilize inverse ETF options for hedging or speculating.
When using inverse ETFs to hedge, investors should not go overboard with their allocations. Instead, the inverse ETFs should make up a small percentage of an overall long equity portfolio to help diminish any downside risks.
For instance, if an investor believes the markets will pullback over the short-term, one could sell off his or her full equity position and potentially trigger tax consequences and incur transaction costs. Alternatively, an investor can add an inverse S&P 500 ETF to hedge the portfolio and help diminish the volatility of the combined portfolio.
For the more risk-tolerant speculators, inverse ETFs can be used to directly profit off the miseries of the markets as the inverse options are used for bets on market turns. While traders have been capitalizing off market turns through short selling options, ETFs provide an easy-to-use alternative to get in an out of a short position, and the funds only exposes a trader to potential losses up to the purchase amount, whereas short sales can expose a trader to unlimited losses.
More aggressive traders can also leverage their bearish outlook with the ProShares UltraShort S&P500 ETF (NYSEArca: SDS), which tries to reflect the -2x or -200% daily performance of the S&P 500, the Direxion Daily S&P 500 Bear 3x Shares (NYSEArca: SPXS), which takes the -3x or -300% daily performance of the S&P 500, and ProShares UltraPro Short S&P 500 ETF (NYSEArca: SPXU), which also takes the -300% daily performance of the S&P 500. However, while the leveraged options provide potentially greater returns, these ETFs also come with greater risks. [Inverse S&P 500 ETF Ideas to Hedge a Correction]
For more information on inverse strategies, visit our inverse ETFs category.
Max Chen contributed to this article.