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Is Cambria's Global Asset Allocation ETF Right For You? Find Out Here.

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ETFs have become a staple product in most traders’ and investors’ arsenals. Active traders have embraced ETFs, and ETF issuers have responded by giving these traders tactical access to nearly every corner of the global investment market. Inverse ETFs or “bear funds”, which increase in value as the underlying asset declines in value, are one such tactical tool. But is it better to short-sell or buy an inverse ETF?

To answer this question, we’ll look at when it’s prudent to be bearish, how to short-sell, how inverse ETFs work, and which method fits best with a set of particular financial goals or trading strategy.

Be sure to read How to Take Profits and Cut Losses When Trading ETFs.

How to Be a Bear

Being bearish means expecting an asset’s price to decline and taking a position to capitalize if that expectation comes to fruition.

man with umbrella

While it has become much more commonplace for retail investors to take short positions or buy inverse ETFs, many are still wary, viewing it as too risky. Yet shorting or buying inverse ETFs can be a valuable tool, and can actually help traders and investors achieve their financial objectives. Markets don’t always rise, so only trading the long side means missing out on a potential profit when markets decline. Utilizing short-selling strategies or buying inverse ETFs during declining markets, and using bullish trading strategies during rising markets, allows for a maximization of profit potential across both rising and falling markets.

To learn more, be sure to read Everything You Need To Know about Short ETFs.

What is Short-Selling?

When buying and ETF, investors are anticipating that the price will rise and that at some point in the future they’ll be able to sell it for a higher price than they paid. Buy first then sell. Short-selling on the other hand, means anticipating a price decline; therefore investors will want to sell at today’s price, and then hopefully buy back the ETF at a lower price in the future. The difference between the two prices would be the profit. Sell first then buy.

Assume the SPDR Gold Trust (GLD A-) is trading at $130, and you believe it’ll decline in value. You short-sell 100 shares and receive $13,000 (less fees and expenses) into your account. You have $13,000 from the sale but your account shows a negative 100 share balance, which means you’ll need to buy back those shares, called “covering”, at some point in the future. If the price rises to $150 and you cover, it’ll cost $15,000 to buy back 100 shares, resulting in a loss of $2,000 plus fees. But if the price drops to $100 and you cover, it only costs $10,000 to buy 100 shares, and you pocket $3,000 in profit less fees.

The main benefit of short-selling is that investors can profit from falling asset prices. Since many investors only trade on the long/bullish side, trading on the short side means having more opportunity to trade and profit.

Be sure to read the 7 Rules ETF Day Traders Must Know.

man running against the trend

The main risk of short-selling is that while profit is capped (a stock can only fall to zero), risk is theoretically unlimited. In a short position the asset could rise indefinitely, forcing investors to cover at a higher and higher price. This shouldn’t scare anyone though, since a short position can be covered at any time. Most experienced traders don’t view shorting as any more risky than taking a long position as long risk is controlled and stop-loss orders used to help protect capital.

Also, being short in a stock when a dividend is paid out means paying that dividend. A notice will be sent beforehand warning that you may be liable for a dividend payment if you hold your short position past the specified dividend date. You’re liable for the dividend because in order to sell before you buy you need to borrow those shares from someone who already owns them. These are both automatic processes brokers can take care of.

How Do Inverse ETFs Work?

An inverse ETF moves in the opposite direction of the underlying asset. For example, if the SPDR S&P 500 (SPY A) moves up 1% today, the Short S&P 500 ETF (SH A+) should drop by 1%. An inverse ETF creates this effect by taking positions in multiple securities so that the daily gain or loss is the inverse of the traditional index, as in the preceding example.

Inverse ETFs are generally only intended to provide the inverse return on a daily basis. If the Dow Jones Industrial Average ETF (DIA A) moves down 5% over a week or a month, the Short Dow 30 ETF (DOG A) likely won’t be up 5%. Over the long term, investors can expect some disconnect between gains and losses on a traditional ETF and the gains and losses on the corresponding inverse ETF, due to compounding returns and losses on an increasing or decreasing ETF price.

Some ETF and ETN issuers offer inverse ETFs that seek the inverse return on a traditional index over the course of a month. Beyond one month though, the same disconnect typically occurs.

The main benefit of an inverse ETF is that it allows investors to quickly and easily take advantage of falling asset prices. Assuming an investors pays for the position outright (no leverage), their loss is also capped at the amount invested, since the price of the ETF can’t drop below zero.

The main risk is that inverse ETFs don’t always act as anticipated. While on a daily basis an inverse return on the underlying index is expected, over the longer term the return on ETFs can vary drastically from expectation.

Which Approach is Best: Shorting or Buying Inverse ETFs?

hand choosing from options

Invesors wanting specific dollar-for-dollar gains as an asset price drops will want to go short. For example, by shorting the specific stock or ETF, you’ll know that if you have a 200 share position and the ETF drops by $1, you’ve increased your unrealized profit by $200. As long as the ETF continues to decline, your unrealized profit will continue to mount. The downside is that you’re responsible for any dividends that may arise while you’re short. You also may receive margin calls on your trading account if the ETF moves against you (goes up). Shorting is a viable strategy for day traders, swing traders and longer-term traders alike.

See also: How to Swing Trade ETFs.

Inverse ETFs are excellent day-trading candidates, as many are based on the daily inverse price performance of an underlying index. Over short periods of time you can expect that the inverse ETF will perform “the opposite” of the index, but over longer periods of time a disconnect may develop.

Therefore, inverse ETFs are typically used for short-term trading opportunities, or to take advantage of sustained downtrends in major asset classes where sizable gains are likely, even in spite of a possible disconnect. If an index such as the S&P 500 declines by 20% over a couple of weeks, a significant profit can likely still be realized even if the Short S&P 500 ETF (SH A+) doesn’t gain exactly 20%, .

The Bottom Line

There isn’t a definitive answer on which is better, shorting or inverse ETFs; both have merit and are utilized by different types of traders. Inverse ETFs may not act exactly how you expect over the long term since, typically, the fund’s goal is to provide inverse price performance over a specific time frame only. Shorting doesn’t have this drawback, but your potential risk is higher and you may end up having to pay dividends. If you’re a day trader, utilize both methods. For longer-term traders, you’ll need to determine which is more risky to you: the sometimes unpredictable returns associated with inverse ETFs, or the uncapped risk and possible dividend payments on a short position.

For more ETF analysis, make sure to sign up for our free ETF newsletter.

Disclosure: No positions at time of writing.

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