Trade Against the Trend with an Inverse ETF

How to Short Sell without Margins when the Market Falls

Dec 9, 2008

Short selling is not the only way to profit in a down market. An inverse exchange traded fund (ETF) can offer an easier and safer way to capitalize on market weakness.

An inverse ETF offers a diversified portfolio which aims to generate returns similar to short selling the components of a sector or an index. Inverse ETF shares can be purchased just like shares of common stock.

Why Not Just Short a Stock?

Short selling is one way to profit when the stock market drops, but short selling is only available to margin account holders. The use of borrowed funds or shares makes trading on margin more risky than trading from a cash account.

The added risk comes from the account holder's assumption of debt to facilitate trading. If the underlying stock moves against the margin position, any losses must be covered and interest must be paid on the borrowed funds.

Purchasing shares of an inverse ETF reflects a long position which can be completed through a cash account.

ETFs Can Reduce Risk

Aside from the excess costs and risks associated with margin trades, it is extremely risky to invest in individual stocks. Any good financial advisor will tell you not to put all of your eggs in one basket because any position, long or short, in just one stock will be the sole determinant of your account balance.

An inverse ETF is a more diversified alternative because the fund’s portfolio shorts an index or a sector. For instance, if you are bearish on the financials sector you can purchase an ETF that shorts the sector. If you are bearish on the market as a whole, you can purchase an ETF that shorts an index such as the Dow Jones Industrial Average or the S&P 500.

As the components within the sector or index decrease in value, the value of your shares held in the inverse ETF rises.

Betting against the Market Can be Risky

The number of securities contained within an index automatically reduces the portfolio’s risk. However in volatile markets, even indexes can have relatively large daily swings. In the long-run, history shows that markets generally provide positive annual returns and a bullish period for an index equates to a bearish period for the holder of an inverse ETF.

Keep an Eye Out for Liquidity

Some of the most active issues are ETFs, but some of their inverse counterparts trade less frequently. Before buying an inverse ETF, be sure to examine the fund’s average trading volume. If volume is thin, you may encounter a larger bid/ask spread when attempting to sell your shares.

Watch How the ETF Tracks the Index

ETFs are designed to mimic the performance of an underlying portfolio, but it can be difficult to perfectly and consistently mirror the portfolio. It can be even more difficult for an inverse ETF since its returns are expected to represent the equal and opposite effect of taking a long position in the underlying portfolio.

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