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Inverse ETFs Explained

Jason BondJason Bond ·

New to the trading/investment world? You should consider learning the intricacies of exchange-traded funds (ETFs) before you start digging in and doing a bunch of technical analysis… or god forbid, start “investing” in them, as the outcome could be devastating. The basic idea behind inverse ETFs is to provide market participants with returns that are inverse, or -1x, the daily performance of their underlying indices. That said, these could provide trading opportunities, if you understand the functioning of this type of exchange-traded product.

Inverse Exchange-Traded Funds (ETFs) Explained

An inverse ETF is an exchange-traded product (ETP) that is constructed using derivatives, such as index swaps, in an attempt to provide investors with inverse exposure to the fund’s underlying benchmark. Therefore, inverse ETFs could be used to gain short exposure to index-tracking ETFs that are hard to borrow (HTB) or not optionable. Think of buying inverse ETFs as holding a short position on index-tracking ETPs.

Now, an inverse ETF is not meant to track its underlying benchmark index’s long-term performance. Rather, an inverse ETF only tracks the inverse of the daily performance of the underlying index. Therefore, you should never hold onto an inverse ETF for periods longer than one day, as the performance over that period could deviate from your expectations, due to the compounding of daily returns.

One main advantage of inverse ETFs is that they don’t require market participants to hold a margin account in order to gain short exposure to an index. Rather, all they would need to do is get long the stock, and if the index or benchmark declines, the market participants would begin to profit. The opposite is true when the underlying index rises.

Final Thoughts

Inverse ETFs provide short exposure to underlying benchmarks, or indices, for a one-day period. Now, before going out and trading inverse ETFs, you should read the prospectus and do your due diligence before trading a specific inverse fund. Moreover, you shouldn’t hold inverse ETFs for periods longer than one day because the effects of the compounding of daily returns could increase the tracking error of the fund.

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  Jason Bond runs JasonBondTraining.com and is a swing trader of small-cap stocks.

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