Inverse ETFs are best used for trading, rather than to buy and hold for the duration of a bear market. Non-traders looking to hedge their longs or profit from the bear market should consider long-term put options instead. Contrary to popular belief, options can require less expertise and offer a lower overall risk to a portfolio than short ETFs.
The main problem with short ETFs is that as the underlying indexes get lower, small dollar moves become large percentages, especially in 2X funds. This math works against you as the market exhibits volatility on its way down. A dollar of loss in an index wins you a smaller gain in your short fund than a dollar of gain in the index from that lower level gives you a loss in your fund. Here’s an illustration:
Imagine if XLF (a financial index ETF) goes from 20 to 19 one day, and SKF (SKF’s 2X inverse) goes from 100 to 110.
$1 out of $20 is 5%, so SKF goes up 10%
$1 down = $10 up
The next day XLF goes from 19 to 20, so SKF goes to $98.42 . $1 out of $19 is 5.26%, so SKF goes down $11.58.
XLF is back where it started, but SKF is down 1.42%.
As many have learned in the bounce from the July 15 lows, this math can be brutal with larger percentage swings, and these moves will only get wilder as the market goes lower.
LEAPS are lower risk than short ETFs (in smaller quantities)
If you are very confident about financials or REITs or the broad market going lower and are not a proven trader, use LEAPS (Long Term Equity Anticipation Securities), long-dated options. The whole idea behind the existence of an options market is to decrease risk. Make the concept work for you.
You can buy January 2010 puts on XLF, IYR, SPY, IWM, QQQQ, whatever you want, and just sit tight. 2011 LEAPs are being rolled out, and December 2010s are available on SPY. Don’t trade in and out if you aren’t a pro. Those blistering rallies on the way down won’t change the fantastic percentage gains that await if you have the longer trend right.
So many people risk big chunks of money in double short ETFs, and then screw it all up through bad trading, when they could just put a fraction of the money into LEAPS puts and get out of their own way, with the ultimate dollar gains being the same in the end. The balance saved can be kept safe in treasury bills, and those could be a lifesaver if things get really hairy and the markets are compromised. This strategy offers lower risk than inverse ETFs without sacrificing potential gains.
LEAPS may also offer reduced counterparty risk due to the rules of the options market, as opposed to whatever wizardry the investment banks use to make those funds do what they do.
FAQ: How high can inverse ETFs go?
For the record, the theoretical gains in any short ETF are unlimited. You can always go down another 1% or 10% or 50%, no matter how low an index goes, so a short ETF can keep going up by the same (or double) percentages forever. The catch is that volatility and the math explained above will keep things down to earth.
Don’t dismiss cash. It’s in a bull market.
I am not recommending shorting to anyone. Only you can decide what may be appropriate, and the key to getting through the next few years will just be to come out with your capital intact. That will be heoric enough.