fbpx

Everything You Need to Know About Inverse ETFs

 

L earning the ins-and-outs of exchange-traded funds is important whether you’re new to trading or you’ve been doing it for a while. Because trading inverse ETFs, specifically the inverse VIX, is so complex, it is typically best left to traders that have experience and/or a deep understanding of how they work. By doing your research before you begin, you can increase your chances of success and ensure that you’re investing in a trading instrument that aligns with your risk tolerance and your goals.

What Is an Inverse ETF?

Image via Unsplash by markusspiske

An inverse ETF, or exchange-traded fund, is an exchange-traded product (ETP) that is comprised of various derivatives and assets, like index swaps or options, in an attempt to help investors profit from a drop in an underlying benchmark’s value.

In other words, an inverse ETF, which is sometimes referred to as a “short ETF” or “bear ETF,” is basically an index ETF that increases in value when its correlating index’s value decreases.

Investors often use inverse ETFs in their investing strategy when they have a risky amount of exposure to a certain region, sector, or index because it allows them to protect their portfolio from that overexposure. As a result, investors get downside exposure in the marketplace and are able to make investments that are a little less risky.

How Inverse ETFs Work

A majority of inverse ETFs rely on daily stock futures to generate their returns. Stock futures, sometimes referred to as futures contracts or just futures, are contracts that buyers and sellers use to negotiate the price and date of a future stock transaction. Once the agreed-upon date rolls around, the buyer and seller are obligated to complete the transaction at the stated price regardless of any changes that might have occurred to the market price. Essentially, they allow investors to make a bet on the direction a security’s price will go in.

When it comes to investing in inverse ETFs, derivatives, like stock futures, give investors the ability to bet that the market will drop. If it does, then the inverse ETF increases by about the same percentage as the decline.

Because fund managers purchase and sell derivative contracts on a daily basis, inverse ETFs are short-term investments. You should really only hold onto an inverse ETF for one day or less since the compounding of daily returns could cause the asset’s performance to stray from your expectations.

Because of this, it’s impossible to guarantee that an inverse ETF will accurately reflect an index or stock’s long-term performance. Additionally, trading so frequently usually impacts the fund expenses, causing the expense ratios of some inverse ETFs to reach or exceed 1%.

Inverse ETFs vs. Short Positions

Investing in inverse ETFs is a lot like holding several short positions, which is when investors borrow securities and sell them in the hope that they’ll be able to repurchase them for cheaper. Unlike with short positions, investors aren’t required to hold a margin account when entering into an inverse ETF, meaning a broker doesn’t have to lend an investor money to trade.

Aside from needing a margin account, shorting requires investors to pay brokers a stock loan fee. When stocks have a high short interest, it can drive up the cost of short selling. A lot of the time, the cost tied to borrowing shares can be upwards of 3% of the borrowed amount, making this trading strategy particularly risky.

Inverse ETFs, on the other hand, often have an expense ratio of 2% or less and can usually be purchased by anyone who has a brokerage account. Basically, it’s both easier and less expensive to trade inverse ETFs than it is to short stocks.

Types of Inverse ETFs

There are quite a few different types of inverse ETFs, including inverse ETFs that focus on certain sectors, like consumer staples, energy, or financials, and those that are used to profit from drops in broad stock market indexes, like the NASDAQ 100 or the Russell 2000.

In some cases, investors use inverse ETFs so that they can make a profit when the market dips down, but there are some that use them to hedge their portfolios. For example, if you own an ETF in the S&P 500, you could hedge, or protect, your portfolio against dropping prices by purchasing an inverse ETF that matches the S&P. Essentially, this lowers your risk level because it gives you a way to profit even if things go wrong.

Though hedging can be really helpful if the S&P index declines, you could end up having losses that offset any profits from your original ETF investment if the S&P starts to rise. In this case, you would need to sell your inverse ETFs to eliminate the risk. Aside from that, inverse ETFs are short-term trading tools, meaning in order to make money from them, you have to time your trades perfectly. When investors poorly time their entries and exits or funnel too much money to their inverse ETFs, they can risk some pretty significant losses.

Benefits of Inverse ETFs

I nverse ETFs and standard ETFs share a number of the same benefits, such as tax advantages, lower fees, and ease of use. Aside from that, there are a few benefits that are more specific to inverse ETFs, most of which have to do with the different ways that they allow you to place bearish bets. Buying shares in an inverse ETF allows investors to take an investment position similar to what they would have achieved if they were short-selling an index or ETF without needing a brokerage or trading account to do it.

Inverse ETFs are admittedly a bit riskier than traditional ETFs, but because you buy them outright, they carry considerably less risk than other types of bearish investments. For example, shorting an asset carries risks that are essentially unlimited, which can result in investors losing way more than they originally expected to. On the other hand, when holding inverse ETFs, investors can only lose as much as they spent to purchase the ETF. Even if the inverse ETF ends up being completely worthless, the threat of owing a broker or anyone else money isn’t there.

Challenges of Inverse ETFs

One of the primary disadvantages of trading inverse ETFs is the lack of selection. Since they aren’t as popular as traditional ETFs, investors are usually stuck with less demand and fewer options, which results in them having a bit less liquidity.

Aside from their lack of popularity, another risk associated with purchasing inverse ETFs is that major stock indexes have a long history of rising. In other words, it can be risky to use a buy-and-hold strategy when purchasing inverse ETFs because, historically speaking, indexes eventually make a comeback despite any losses. Because of this, it’s important for inverse ETF investors to closely monitor the markets so that they can exit their position before the corresponding index bounces back.

What Are Inverse Volatility ETFs?

Inverse volatility ETFs are connected in an opposite relationship to volatility futures contracts based on indexes. The most notable inverse ETF is the VIX, or the Chicago Board Options Exchange Market Volatility Index.

Put simply, the prices of these funds have adverse reactions to the VIX, dropping when volatility peaks, and spiking when volatility plunges.

Inverse VIX ETFs are extremely complex instruments, which is why they are primarily used by experienced traders. Part of what makes them so complex is that a VIX ETF inverse can’t be bought or sold directly. Unlike more traditional inverse ETFs, you have to indirectly short the VIX ETF.

Though often used interchangeably with volatility ETFs, there are also volatility exchange-traded notes, or ETNs. Perhaps one of the largest and most liquid stock market indexes in the volatility realm is the iPath S&P 500 VIX Short-Term Futures ETN (VXX). With the inverse VXX ETF, the S&P 500 moves opposite of the VXX. In fact, there is more potential for gains here than a regular short volatility ETF because the movements of the VXX usually exaggerate any moves that happen in the S&P 500.

Trading Inverse Volatility ETFs

When trading on the ProShares Short VIX Short-Term Futures ETF (SVXY), you purchase VIX when you short the ETF, or the VIX stock futures. Because the S&P 500 is the inverse of the VXX, the best way for a day trader to turn a profit is to buy VXX when the index is experiencing a decline and to short VXX when the S&P starts to rally.

W hen it comes to trading inverse ETFs, there are definitely risks, but the rewards make it worth it for a lot of investors. Though knowledge is just as important as experience for almost every type of investing, it’s especially beneficial before you begin investing in inverse ETFs. VIX inverse ETFs are particularly complex, but by familiarizing yourself with them, you can increase your chances of success and your profitability.