ETF traders have often looked at inverse and leveraged options to hedge their market exposure or capitalize on sudden market turns. While traders may feel good capitalizing on sudden market misfortunes through leveraged inverse ETFs, investors may think about incorporating a smaller hedge to limit stock pullbacks.
“We want to see people use lower level leverages in a smart way,” O’Rourke said.
For example, the ProShares Short S&P500 (NYSEArca: SH) and Direxion Daily S&P 500 Bear 1x Shares ETF (NYSEArca: SPDN) take a simple inverse or -100% daily performance of the S&P 500 index. Investors could included a small position of around 5% of their total equity portfolio to hedge against any potential turns that would negatively affect their long stock exposure.
“An investor who believes a stock he wants to continue to hold will fall could try to hedge against its decline by buying an investment designed to move in the opposite direction. A gain in the inverse investment may help counterbalance a loss in the stock. Another investor who doesn’t own the stock may ‘short’ it to try to profit from a potential decline,” according to ProShares.
Potential investors should be aware of the risks associated with these inverse products. These ETFs rebalance on a daily basis, so the inverse funds may not perfectly reflect their intended strategies over long periods due to compounding issues as a result of the daily rebalancing.
In Trending markets that move consistently in a single direction, compounding may benefit inverse ETFs. However, in more volatile markets when securities experience greater oscillations, an inverse ETF may underperform its intended -1x, -2x or -3x multiples compared to a benchmark.