What goes up, must come down.
This is as true for the financial markets as it is for gravity. While equity indices may trend upward in general as expanding economies and new technology drive up the value of companies, this overall trend is punctuated with regular, and often sharp, reversals downward.
Buying into a bull market is as simple as buying a basket of stocks that you like or buying an exchange-traded fund (ETF) that tracks the value of an index, industry sector or group of companies. Selling into a bull market, on the other hand, can be a little more complicated. You can short stocks or ETFs, but this is a complicated process that is expensive, has limited availability and is vulnerable to the dreaded short squeeze that market bulls do not need to contend with.
That is why inverse ETFs are a great way to take a short bet against the market without exposing yourself to the difficulties and risks of short selling. These ETFs will do the shorting for you, and all you need to do is buy the ETF and hold it for a profit.
The mechanics involved in ETFs in general and short selling in particular means that the various inverse ETFs available have a variety of different features that may appeal to different kinds of bearish traders. It is important to study how the various inverse ETFs work so that you are sure that you are using the right one for your bearish trading strategy.
Here are the top 5 inverse ETFs for taking out your bearish bet against the equity markets.
ProShares Short S&P 500 (SH)
The ProShares Short S&P 500, or SH, is based on the S&P 500 as a benchmark. It uses derivatives, including stock options, swaps and futures, to emulate the reverse of the price action in the S&P 500. It is important to note that the S&P 500 is based on large and middle capitalization companies, which means that it is considered the premier benchmark for the general American economy.
SH is only intended to be used one day at a time as a result of how its basket of securities is formulated. Therefore, investors can avoid the effects of compounding by selling their holdings in SH before the end of the trading day.
SH is a highly liquid ETF. Although it has a high fee, this fact is mitigated by the short holding period that it is designed for. Traders who use SH should look at the trading cost of buying and selling the ETF, as the impact of the fee will be negligible if used to trade tactically.
SH is ideal for making quick bets against the American equity market, particularly in times of domestic or international uncertainty or following poor economic data prints.
ProShares UltraShort S&P 500 (SDS)
The ProShares UltraShort S&P 500, or SDS, is also based on the S&P 500. It is very similar in structure and ideal implementation to the ProShares Short S&P 500 (SH) ETF, but offers similar exposure with 2x leverage.
This added leverage allows investors to achieve greater profits from short and sharp downturns in the American equity markets.
ProShares UltraPro Short S&P 500 (SPXU)
The ProShares UltraPro Short S&P 500, or SPXU, is similar to both the SH and SDS ETFs, but offers the investor exposure to a 3x leverage short position against the S&P 500.
The highly leveraged nature of this ETF exposes the investor to sharp swings in profitability, but the very high rate of liquidity means that investors can quickly enter and exit trades against the American equity market using this inverse ETF.
ProShares Short Russell 2000 (RWM)
ProShares Short Russell 2000, or RWM, uses ETF and index swaps to bet against the Russell 2000 small capitalization index. The Russell 2000 index tends to be more volatile than the S&P 500, and is particularly responsive to American domestic political uncertainty and changes to tax and labor legislation.
The RWM ETF is designed for one day use, and holding it for longer than one day will lead to compounding. The ETF has high fees, but is not intended to be held for extended periods. The high liquidity and tight spreads of RWM make it ideal for quick tactical bets against the Russell 2000 index.
ProShares UltraPro Short (SQQQ)
ProShares UltraPro Short, or SQQQ, offers investors inverse exposure to the NASDAQ 100 technology index. The ETF is structured using swaps on shares within the NASDAQ 100, swaps on the NASDAQ 100 index itself and futures. SQQQ is a 3x leverage inverse ETF that is only intended to be held for less than one day, otherwise the investor is faced with the compounding effect.
Trading with Inverse ETFs
All of the top 5 inverse ETFs are intended to provide traders with a brief inverse exposure to certain sectors of the American economy and equity markets. These ETFs are not designed for long term strategic trading positions, but rather for short term profit taking resulting from sharp downturns in American equity indices.
Some common reasons to use these ETFs are rising international tensions, domestic political crises, poor economic data prints, adverse Federal Reserve decisions or statements and changes in domestic tax and labor legislation.
The high expense ratio involved in all of the top 5 inverse ETFs means that positions should be timed well and closed soon after any sharp downturns in the underlying index to avoid reduced profitability. In addition, ETFs have trading costs that can further reduce profitability, so positions should not be opened and closed repeatedly when avoidable.
Investors should be cautious when using leveraged inverse ETFs, as losing positions can turn negative at an accelerated rate, particularly during times of high uncertainty and volatility when these inverse ETFs are most often in use.
Fortunately the high liquidity of all the top 5 inverse ETFs means that investors can quickly and efficiently enter and exit short positions against American equities without fear of being stuck in a losing position or experiencing slippage that eats into profits or further extends losses.