When hopes of a profitable bullish position get dashed when the trade moves the other direction, it can help to shift into reverse with inverse exchange traded funds (ETFs).
Inverse ETFs add a tactical hedging position to minimize losses when a long (or bullish) position goes the other direction. It can also be used as a trader’s sole short position when their bearish convictions are high. However, leaving a position unhedged comes with a lot of risk.
Either way, short-term investors or day traders can use inverse ETFs as part of their toolboxes to attack the markets. But what exactly are inverse ETFs?
Inverse ETFs live up to their names — they go in the inverse (or opposite) direction of the index they follow. So an ETF that follows the S&P 500, for example, can be hedged with a position in an inverse ETF. If a trader is bullish in an S&P 500 ETF, but it starts to trend downward, they can hedge the position with an inverse ETF that profits from the downtrend.
Inverse ETFs can give a trader flexibility in the markets, which is crucial for profitability. Because the markets are so dynamic, having that extra bit of fluidity when market conditions change is helpful.
Short Selling Without a Margin Account
Holdings of an inverse ETF can consist of futures contracts, derivatives, swap agreements, and similar products. The commonality is that the ETF is betting on a future price. In the case of inverse ETFs, they consist of bets that the price of the underlying asset will go down.
Given this feature, inverse ETFs allow traders to go short without the use of a margin account where a trader borrows money from a broker. The short component is essentially baked into the fund. Rather than take a short position using a margin account, a trader can simply allocate capital into an inverse ETF and achieve the same position. As such, a trader doesn’t have to borrow funds in order to trade an inverse ETF.
In the case of leveraged ETFs, traders can also amplify their gains, assuming the trade goes favorably. ETF providers like Direxion Investments offer leveraged ETFs so traders can take a bearish position and maximize their profit potential since they have the leverage built into the ETF. This leverage can be two or three times the position, depending on the fund.
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