Inverse ETFs: What They Are And How To Trade Them
One trading strategy relevant to traders during a bear market is inverse exchange-traded funds (ETFs). Inverse ETFs have a unique design since these investment products use derivatives that profit from a decline in the value of an underlying benchmark. These products are available to purchase as you would a typical ETF, but their use in trading is significantly different.
How Do Inverse ETFs Work
An inverse ETF is an exchange-traded fund (ETF) that is constructed to allow investors to make money when the market or the underlying index declines. This can be an essential option for traders with accounts that don’t give them the ability to sell anything short. For instance, cash accounts and Roth IRAs do not allow traders to short their position.
With Inverse ETFs, traders can take advantage of market downturns and take short trades with the accounts that don’t give them the option. Inverse ETFs don’t typically require traders to have a margin account for the trader to enter short positions.
While some traders opt for a “flight to safety” in the commodities market with gold, silver, utilities, and other safer positions, some want to trade the exact market to the short side. These traders can consider the inverse ETFs that perform similarly to a short trade. There are numerous inverse ETFs available for trading through brokerage firms. However, some are better than others, and the fees tend to be higher than traditional ETFs.
How To Trade Inverse ETFs In Bear Markets
ETFs can be used to profit from bear markets and declines in market indexes, such as the S&P 500, Russell 2000, or the Nasdaq. Some inverse ETFs focus on sectors such as financials, energy, or consumer staples. These products can be especially popular with traders who primarily trade just stock rather than options.
Some inverse ETFs are linear, meaning the price rises or falls on a one-to-one basis, while others follow a two-to-one return ratio. However, ETFs can be twice what the market does or three times what the market does of that ETF. These are called Double and Triple Inverse ETFs.
Leveraged Inverse ETFs
These leveraged inverse ETFs refer to funds that use derivatives and debt to magnify the returns of an underlying index. Typically, the price of an ETF rises or falls on a one-to-one basis compared to the index it tracks. A leveraged inverse ETF is designed to boost the returns to 2:1 or 3:1 compared to the index.
Leveraged inverse ETFs use the same concept as leveraged products and aim to deliver a magnified return when the market is falling. For example, if the S&P has declined by 2%, a 2x-leveraged inverse ETF could provide a 4% return to the investor.
To find leveraged ETFs, the trading platforms show traders based on the description of what it is and the trading instrument. By looking further, the description indicates this is the “bear” ETF – as indicated by “BR.” This means if the market goes down, the ETF gains in value. Should the ETF indicate it is the 3x, it’s leveraged three times.
Traders searching for inverse ETFs can research ETFs available through their brokerage firm or trading platform. They can see what’s available and narrow their search depending on the market segment they like.
Inverse Volatility ETF List
The importance of understanding market direction and trending stocks can’t be stressed enough. Traders who aren’t adept at using charts and indicators could suffer significant losses if they aren’t studying the broader market. Inverse ETFs are short-term trading instruments whose entries and exits must be well-timed.
In a “whiplash” market environment where directions can change on a dime, scaling to limit exposure in inverse ETFs can help prevent the significant risk of losses. By monitoring the charts and indicators for volatility, volume, and other criteria, traders could use an inverse ETF to take advantage of a rip upward in a bearish trend. This would enable a trader to buy into a bear market, and take advantage of an index, such as the S&P 500.
Traders looking to short the Volatility Index (VIX) will find the U.S. ETF market has an inverse volatility fund trading available. The -1x Short VIX Futures ETF (SVIX) and the 2x Long VIX Futures ETF (UVIX) debuted on the Cboe Global Markets. These ETFs provide inverse and double returns on an index that tracks the short-term VIX futures over a single day.
The shorter time frame presents a more targeted approach, especially when compared with the ProShares Short VIX Short-Term Futures ETF (SVXY) and the ProShares Ultra VIX Short-Term Futures ETF (UVXY).
The SVIX fund came after “Volmageddon,” when traders saw $2 billion in assets tied to the strategy wiped out. As the markets sold off with a steep rise in options volatility, an exceptional amount of VIX futures were purchased. This lack of liquidity potentially contributed to the sell-off in S&P futures.
Caveats of Inverse ETFs
Inverse ETFs are not without risk, and their performances have no guarantees. Traders should remember that these instruments shouldn’t be considered for long-term investments since the fund’s manager buys and sells derivatives contracts daily. As a result, there is no way to guarantee that the inverse ETF will match the long-term performance of the index or stocks it is tracking.
The expense ratios are usually a little bit more expensive than traditional ETFs. Traders should understand that since inverse ETFs aren’t geared toward a buy-and-hold approach, the high expense ratios should be factored in.
Traders shouldn’t look to buy these products with the strategy to hang on to them for a year or two or even a few months. These investments are primarily beneficial to take advantage of downward movement.
Traders also want to know whether the inverse ETF is one-to-one or leveraged. Traders could mistakenly assume the risk is 2% when in actuality, it is 6% because they bought a 3x.
Traders would do better in finding popular ETFs than an obscure ETF of a sector that doesn’t have anyone investing in it. Two things to look at are the average volume of the more significant assets in the ETF and the ETFs that have increased in popularity. This can indicate that an ETF could be less likely to falter.
Traders can also observe the volume of shares moving on a low day to see what that looks like. Should they find its average is a half-million, this could indicate that when things pick back up, a lot of the volume will go back into them. That could indicate that’s where traders want to be.
Short Market Advantage
In summary, investors and traders tend to flock to commodities and sectors generally regarded as less volatile when the market isn’t performing too well.
Shortening the market through inverse ETFs allows traders to take advantage of a bear market or falling prices. Some trading accounts don’t allow you to short trades, so this offers a different means to short the market – although not without risk.
Going short in a bear market can be a trader’s advantage, but since stocks behave differently in a downtrend, traders should be careful. Understanding what the market is doing and where you are going with your trade is essential. A market that has been short for the past two weeks may not be today.
Trading is risky; regardless if you are trading ETFs or inverse ETFs, it all comes with risk. If you are looking for guidance and mentorship, consider joining TG Watkins in his trading program, the Moxie Indicator™ Mastery. Traders can get together monthly and trade alongside TG Watkins. Sign up today and access real-time trade alerts, his trade spreadsheets, and exclusive informational downloads. Why trade alone when you can trade with us? Become a member today.
FAQs on Inverse ETFs
A: A good strategy to find an inverse ETF for your trades is to look for inverse ETFs in sectors, indices, and industries you already know. It’s possible to research using a search engine or by using the Inverse ETF database.
A: Traders should be aware that hedging rarely, if ever, results in a trader making large sums of money. A successful hedge prevents losses which is what the inverse ETF is designed to do. Traders who successfully hedge can be profitable and minimize losses in a bear market, but there is no guarantee. There are still risks with market movement and volatility in a bear market.
A: Inverse ETFs are designed to magnify the one-day returns of a benchmark index. Holding for a longer period of time does not benefit traders.
A: High short interest means that there is an unusually high number of traders shorting the stock – and when it becomes evident that they are wrong due to the rising price, they start to panic.
A: Traders tend to panic, and, as the price climbs further, their stops get taken out, which further accelerates the buying of the stock. Traders are forced to buy back their shorts (or cover), which causes a pop in price.