Know When to Use Inverse ETFs - dummies

By Paul Mladjenovic

Inverse exchange-traded funds (ETFs) are a high-powered bearish tool, so you don’t whip them out for just any old occasion. You need a plan, and you resort to inverse ETFs when conditions warrant their use. Following are two such occasions.

Speculating

Speculating is the primary rationale for using inverse ETFs. When you’re diligent about your research and you come across situations where a market or type of investment is troubled — or when an investment seems like it’s been rising forever — then start considering inverse ETFs.

Many seasoned speculators see two optimal moments for putting inverse ETFs into play:

  • A troubled investment is starting to tumble, and you want to get in as it gathers steam and starts to snowball downward (steam and snowballs don’t mix, but you know what I mean).

  • An investment is experiencing a jubilant market, and it seems like everyone thinks it’s going to the moon and beyond — then you may have a good early entry point.

Of the two, the second scenario is a little less risky. When an investment reaches nosebleed territory, the price of the inverse ETF is probably very cheap. The double short ETF is probably dirt cheap, and the triple short ETF is so cheap that they’re giving away free toasters to the first 100 speculators.

When you are bearish and are seeking shorting opportunities, timing is everything! Both the entrance and the exit are timing issues. Keep in mind that over the long term, markets (especially stock markets) have an upward bias. When shorting, getting out too early for profits will still be less dangerous than holding out for more.

Hedging

Bull markets zigzag upward, and bear markets zigzag downward. When an investment is in what’s called a secular or long-term bull market, pullback or interim “bear markets” may occur along the way. Sometimes these pullbacks are severe, and sometimes it looks like a bad market has just arrived and that the value may start to zigzag downward.

Given that, some folks see inverse ETFs as a hedge or a type of protection or insurance in the event of tumbling or decreasing prices that could erode the wealth they built up during the bullish market moves.

Using the inverse ETF could add another dimension to your wealth-building and wealth-protection strategies. For example, suppose you have an extensive portfolio of diversified, dividend-paying stocks and you’re in your pre-retirement years, but you’re convinced that a major stock market pullback or bear market is coming. What would you do? Some investors may hedge by getting an inverse ETF that goes up when the major market goes down.

A good example of a hedge against a market decline is the inverse ETF Proshares Short S&P 500 (SH), which is constructed to go up when the general market is down (to the extent that the S&P 500 represents the general market). When the coast is clear, you can cash out SH at a profit and then turn around and use the proceeds to buy more of your favorite dividend-paying stocks at lower (more attractive!) prices, which means you get a nice locked-in dividend yield. Enjoy your retirement!