eSignal - Smarter Trading Tools

Stock trading strategies for market corrections: Harnessing inverse ETFs

August 19th, 2014

071414_bull-bear By Graeme Ballard, eSignal and Advanced GET Trading Specialist

Interested in generating some gains the next time there’s a market correction? One way to do so is using inverse exchange-traded funds.

Inverse ETF basics
These financial instruments, introduced in the 1990s, were designed to move in the exact opposite direction of an underlying stock market index. In other words, if the S&P 500 loses 2 percent during a session, its inverse ETF – the ProShares Short S&P 500 – will rise by the same amount.

There are other methods – including short selling assets and trading options – that can be used to obtain the same result. However, these alternate approaches have their own unique limitations and can carry substantial risk.

For example, short selling requires getting a brokerage account margin-authorized. In addition, the broker may not be able to find the shares needed when you want to sell them. Alternatively, the investor who lent the securities may want them back at an inopportune time.

Derivatives trading is an endeavor where an investor can either generate outstanding returns or lose his shirt. The value of positions can change very quickly – even more rapidly than stocks – and these shifts can leave investors high and dry.

Drawbacks of inverse ETFs
Inverse ETFs, just like derivatives trading and short selling, carry their own drawbacks. These ETFs use swaps and futures contracts in an attempt to generate the exact opposite of the underlying asset’s movement. Since they harness these financial instruments, inverse ETFs must rebalance their portfolio at the end of each day, which can generate tracking errors.

These small errors can add up over time, and the resulting difference can frighten some investors, Forbes contributor Sy Harding noted in an article. However, Harding emphasized that inverse ETFs were not created to be held through the market’s ups and downs. Instead, they were designed so investors could hold them through a market drop.

These tracking errors can become far worse if market participants decide to work with leveraged inverse ETFs, he stated. These financial instruments were created to deliver a return between two- and three times the opposite of their underlying index.

While using inverse ETFs can provide strong returns when the market corrects, never employ these in stock trading strategies without conducting the required due diligence. Be sure to carefully compare these methods to others that can generate the same results.