The recent drop in the market sent investors into a tailspin, so we’re here to help explain how to use an inverse ETF to make money in a down market.
No matter what causes investor panic, the result is still the same — markets fall.
In that instance, investors try to find different ways to offset some of their inevitable losses, with some fleeing to bonds or gold — otherwise known as safe-haven assets.
But there is another way to capitalize financially on a market drop: inverse exchange-traded funds, or ETFs.
We will explain what an inverse ETF is and how you can make money off them.
What is An Inverse ETF?
An inverse ETF pays a return when the benchmark it tracks is inverse, or opposite the benchmark.
Essentially, when you buy into an inverse ETF that tracks the S&P 500, you are betting that the index is going to go down. You only make money when that happens.
It is very similar to shorting the market, or when an investor borrows securities from a broker or another stockholder and sells them quickly.
What you are looking to do is buy those same shares back at a lower price when it declines, locking in profits after you repay the original lender.
Only with an inverse ETF, you are dealing with futures and contracts, not specific stocks. If the security drops in value, the inverse ETF will jump by a nearly equal value.
For example, if you buy the ProShares Short 500 Inverse ETF (NYSEARCA: SH) you are betting the S&P 500 will go down. If it does, the actual ETF will increase in value.
That is how to use an inverse ETF to make money in a down market.
Risks of Using an Inverse ETF
The biggest thing you have to realize is buying into inverse ETFs is a short-term play.
As an investor, you have to move quickly to leverage a near-term drop in a specific index. If you try to wait an index out, you are likely to lose any gains you would have made had you moved quicker.
“Whether they are leveraged or not, there’s the importance of looking at that as a short-term hedge for your portfolio,” Banyan Hill Publishing research analyst Clint Lee said. “The way that those things are constructed and rebalanced to maintain their inverse ratios, they can actually deviate from that inverse performance over longer stretches of time.”
Once you mix options and futures contracts with the major indexes over a longer period of time, you run a significantly higher risk than you would if you traded an inverse ETF on a daily basis.
“The thing about these inverse ETFs — and I do think they play a role — is that you really have to watch them very carefully,” Ted Bauman, editor of The Bauman Letter, said. “You buy an ETF that moves in the opposite direction of the market, but what you’ve got to do is keep an eye on it. My recommendation would be to put limit-orders on it.”
That limit order would automatically sell your shares of the inverse ETF once it declines by a certain percentage.
So, just like with any trades you make, there are risks to using an inverse ETF to make money in a down market.
The Pros of Using an Inverse ETF
An inverse ETF is there for investors to use as a hedge against a market decline. It’s simply a way for you to still make money when the markets turn south.
Things like the coronavirus or political upheaval in a region can cause markets to trend downward. An inverse ETF can help guard against that.
You can also find a leveraged inverse ETF, which can provide even more gains. In some cases, Bauman said, a leveraged inverse ETF can show you three times the gains of a market loss. If the S&P 500 loses 5%, some leveraged ETFs can provide a 15% gain.
But again, those are tricky. You really have to pay attention to the market on a regular basis and get out of the inverse ETF when signs of recovery start to show.
There is also a wide variety of inverse ETFs that track any number of benchmarks. From large indexes to small-cap funds to gold, there are inverse ETFs out there.
The bottom line is to make sure you do your homework when learning how to use an inverse ETF to make money in a down market.
