The introduction of inverse exchange-traded funds has provided investors with the flexibility to hedge against market movements without having to calculate complex pricing based on volatility, time decay, and other factors. Taking the shine off traditional derivatives, or more specifically, exchange-traded options, the Proshares UltraShort S&P500 ETF (SDS ) offers a liquid, leveraged and manageable solution for both retail and institutional investors.
So how does SDS work and why has this particular ETF gained so much attention?
Mechanics
The Proshares UltraShort S&P500 ETF (SDS ) offers 2x leveraged and inverse exposure to the S&P 500 index. Put simply, a fall in the underlying index will correlate to a rise in the ETF. Returns are compounded on a daily basis, meaning investors holding this fund for multiple periods will need to be aware of compounding returns. As such, SDS is not appropriate for buy-and-hold strategies and should only be utilized by sophisticated investors.
From a cost point of view, SDS has an expense ratio of 0.89%.
For those willing to stomach the risk, SDS can be a powerful tool to make a bearish bet on the broader market or act as a cost-effective hedge.
Be sure to read the 7 Risks of Trading Leveraged ETFs and How to Avoid Them.
Implementation Example
Entry point timing is important when implementing a hedge using SDS. As it is highly leveraged, losses can be significant without proper management in place. In the above example, Investor A is using a volume index overlay to assess specific entry points on a two-year price chart.
- Investor A has a blue chip portfolio of 50 stocks.
- Concerned that the market may react to upcoming economic announcements, Investor A purchases a small holding in SDS. The best way for the investor to calculate the dollar value of the hedge is to understand how their portfolio reacts to movements in the underlying index. In the case of Investor A the portfolio is highly correlated, and a 4% movement in the S&P 500 results in a 3.5% movement in their holdings. They therefore purchase half the portfolio value, taking into account the leverage. (Please note that there is always a degree of error when doing this calculation, and it is almost impossible to have a perfect hedge.)
- Investor A attempts to protect their portfolio by opening four hedges (highlighted in red). Interestingly, in the first three scenarios the price of SDS rises more than 10% and the hedge is rolled over quite quickly. The most recent hedge was a false signal and the lack of movement results in Investor A having to hold on to the position for a longer period.
The Bottom Line
The Proshares UltraShort S&P500 ETF is a great hedging alternative for a short-term trader. Due to the very nature of the product, it can provide a cost-effective and quick solution. Care, however, must be taken due to its high leverage and the compounding nature of returns.
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Disclosure: No positions at time of writing.
