Over the past two weeks, I’ve been discussing this crazy market…why it’s less risky than you might think…and how to invest for maximum profit.
But don’t be complacent: this market is still dangerous…
With inflation hitting 9.1% in June… the Fed cannot afford not to act.
A rate hike as high as 1% after the next FOMC meeting (just two weeks away) is now possible, to hell with recession fears.
And if this next hike fails to rein in inflation, more hikes will follow…and equities could remain under selling pressure.
Luckily for investors, there are ways to fight back…and take advantage of market declines.
I’ve already told you about put options as a way to make money on the downside. But if you’re not comfortable with options, there’s another way…
I’m talking about Inverse Exchange Traded Funds (ETFs).
These funds are specifically designed to take advantage of a downturn in the market or in a particular sector. They are a great way to make money when the market is down, if you use them strategically.
You see, inverse ETFs are not designed for passive investors.
They are highly specialized and designed primarily for short-term trading.
But investors who understand how these funds work and follow the guidelines below can easily use them to hedge their portfolios…and profit when the market goes down.
More importantly, inverse ETFs can be your lifeline in a bear market…
How do inverse ETFs work?
Whether you’re bullish or bearish, there’s an ETF for the direction you think the market (or a specific sector) is going.
A reverse ETF is simply an ETF that promises to deliver the exact opposite of the industry it tracks (or the broader market).
Let’s say that at the end of 2021, you were convinced that the market was due for a sell-off.
To benefit from this, you could have bought the ProShares Short S&P 500 ETF (SH), which promises to provide the opposite of the market return. In other words, if the S&P 500 drops 2%… SH will rise 2% over the same period.
If you wanted to make an even bigger bet, you could have aimed for double the reverse return by buying the ProShares UltraShort S&P 500 ETF (SDS)… or triple the return with the ProShares UltraPro Short S&P 500 ETF (SPXU).
The last two are examples of “leveraged ETFs,” that is, inverse ETFs that promise multiples of the market (or index) return.
As you can see from the graph below, each pick would have made you money this year…and the higher the leverage, the higher the return.
With the market down 20.4% since the start of the year, these inverse ETFs have produced solid gains: a return of 20.8% for SH, 42% for SDS and 61.3% for SPXU.
You can view a list of inverse ETFs here.
Keep in mind: these ETFs have one thing in common…
How are inverse ETFs designed?
Because inverse ETFs use sophisticated financial tools like options, swaps and other derivatives…these funds typically reset their portfolios daily.
Therefore, they are designed to track one day’s performance of a chosen sector (or market)—not its long-term returns.
This may have practical implications…especially for double and triple inverse ETFs: they will lag expected return in a swinging market…
And the higher the volatility – with large fluctuations in the underlying index – the more the actual return of leveraged ETFs will differ from the expected return.
This year, the market declines have been relentless and consistent.
As a result, the above mentioned inverse ETFs provided results quite close to their stated objectives: the market opposite (SH), the double inverse return (SDS) and the triple inverse return (SPXU). You will notice that SDS underperformed its promised return by around 1%, while SPXU underperformed by around 2%. However, it is not far.
But this underperformance can be more significant if the market – or a sector – is particularly volatile.
Take the example of the financial sector.
If you had purchased the ProShares Short Financials ETF (SEF) on December 3, 2021, when I suggested the trade, you would have been looking at a 14.8% gain yesterday.
But as you can see from the chart below… it’s well below the inverse of XLF, the financial sector fund it’s supposed to mirror.
While XLF has lost 19.2% since early December, SEF has only gained 14.8%, 4.4% below target.
And this difference is even more striking for the Direxion Daily Financial Bear 3X ETF (FAZ)… which gained 47.9% over this period, when it was supposed to gain 57.6%. This is another example of the type of “slippage” that can occur when you hold a leveraged ETF for more than a few days.
The most important thing to keep in mind is that these vehicles are designed to keep up with daily changes only. They are a great tool for short-term investors…but the longer you hold them, the more they will underperform their target return.
And the more volatile the market, the more their returns will lag. But if you know what to expect, you won’t be disappointed if it happens.
Bottom line: Inverted ETFs are one of the easiest and most effective ways to profit from a falling stock market.
But to maximize your profits while controlling risk, remember these three simple guidelines:
- Leveraged ETFs are an ideal tool for playing in a market or sector that has a consistent direction…or for profiting when you expect a sudden move in the short term.
- Double and triple leverage ETFs are designed for active trading and are best suited for short-term trading.
- For longer-term portfolio hedging, stick to inverse ETFs that promise the direct opposite (1x) of market/sector returns (like SH or SEF in the examples above).
As long as you remember (and follow) these guidelines, you will be able to make money easily and confidently during a bear market.
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