How Inverse ETFs Compare to Other Bearish Strategies - dummies

How Inverse ETFs Compare to Other Bearish Strategies

By Paul Mladjenovic

Sometimes you want to deploy a shorting strategy but aren’t sure which vehicle is best suited to the bearish opportunity that you’re eyeing. The following discussion covers the most common ways to go short in bearish situations, including inverse ETFs.

Actually going short

Going short is the most direct way to make a profit from the falling price of a particular stock or a regular ETF. Going short is also more hazardous than using an inverse ETF, because you may lose dramatically if you’re wrong. Although unlikely, the outside risk is that you’ll lose more than your initial outlay.

With going short, the most you stand to gain is 100 percent (if that particular stock or ETF has its price go to zero). A stock going to zero indicates that the underlying company went bankrupt. But if that stock or ETF goes up, it’s possible to lose more than 100 percent of your initial “investment” and really take a financial beating.

Going short is the purest inverse play; if you’re seeking 100 percent negative correlation, going short is the strategy for you. If that stock (or ETF) goes down 57 percent, your short position gains 57 percent. This is the upside of shorting (pardon the pun). However, the downside is that if you’re wrong, you have potentially unlimited losses.

Because shorting a regular ETF can be so hazardous, you’re safer getting a put option on that ETF or getting the corresponding inverse ETF (the whole point of this chapter). Yes, you could lose money with an inverse ETF, but at least you won’t get hammered — or be subject to a margin call — the way you could with directly shorting the stock.

Deploying a put option

Options are a popular speculative vehicle. A put option is a bet that the underlying security will go down in the near future. You can buy a put on a stock, a stock index, or an ETF.

The advantage of put options is that they require less capital than other shorting strategies. The disadvantage is that they have a finite lifespan and can expire worthless.

Although put options are generally inexpensive, they have expiration dates (just like that carton of milk in your refrigerator), so they run the risk of becoming worthless. Whether that put option costs you $75 or $750, it can still go to zero. Most options expire in nine months or less.

Considering a put option combination

A put option is 100 percent bearish as a strategy. But what if you aren’t 100 percent bearish? You could use a bearish combination option strategy that’s more refined or more appropriate for you, depending on market conditions.

For example, you could employ a bearish put spread, which is considered bearish but also has a heading feature — a second option coupled with the put option — that makes the trade less bearish. Don’t ask me to explain here. Put options, whether alone or in a combination trade, still have the risk of expiring worthless.

Using an inverse ETF (ta-da!)

An inverse ETF avoids the hazards of going short, and it doesn’t expire as do put options and put option combinations. Also, because the inverse ETF trades like a stock or any other ETF, you can use protective brokerage orders too.

To make your use of inverse ETFs less risky, employ brokerage orders that help minimize potential loss. If your inverse ETF strategy is looking shaky, consider doing a stop-loss order or a trailing stop. The stop-loss or trailing stop order prevents a loss (or a greater loss) but preserves some profit too. For example, say your strategy is working out and you’re sitting on an unrealized gain with your inverse ETF. You think more gain is possible, but then you start to worry about a reversal in the underlying investment’s price. In that case, move to preserve the gain with that stop-loss order or trailing stop.

Suppose that you’re bearish on Sector X, and a regular ETF (fake symbol XB) that mirrors it is at $50 per share. The inverse ETF is the Sector X Short ETF (fake symbol XS), and it’s also priced at $50.

The intent for XS is to act inversely to Sector X. If you’re correct in your expectation that this sector is going down, what happens? If the regular ETF (XB) goes down to $40 per share, then your inverse ETF, XS, goes up to $60 per share. As Sector X goes down 20 percent (20 percent of $50 is $10), your inverse ETF goes up 20 percent to $60. Then you start monitoring to see whether you can realize further gains or you start to be wary and protect what gain you do have.

But what if you’re wrong? Markets are often irrational in the short term. If XB goes up instead, your inverse ETF would go down by a corresponding amount. At that point, you’d have to decide whether to cut your losses or wait for a favorable move.