An exchange-traded fund, or ETF, is a type of security that is traded on formal stock exchanges such as the NYSE or NASDAQ. Like mutual funds, exchange-traded funds are made up of various asset allocations, but they may be traded as stocks are during the standard and extended sessions.
So what is an inverse ETF? Read on to find out the answer to this question and to learn whether these unique instruments are right for your financial situation.
What Is an Inverse ETF?
An inverse ETF is an exchange-traded fund that is designed to deliver returns opposite of the underlying index or asset class. Essentially, it is a security that provides traders with short-side market exposure. Profits are derived from falling asset prices, not the typical “buy low, sell high” mantra of Wall Street. Accordingly, an inverse ETF is commonly referred to as a “short ETF” or “bear ETF.”
To secure bearish market exposure, inverse ETFs consist of various derivative products. By taking short positions in select futures, options, forwards, and swaps, fund managers can essentially “sell” an underlying index or asset class.
Anyone considering the question of “What is an inverse ETF?” should be aware of the two basic types:
- Standard: A standard inverse ETF aims to provide 1X negatively correlated returns on an underlying index or asset class.
- Leveraged: A leveraged or “geared” inverse ETF aims to provide a multiple of negatively correlated returns on an underlying index or asset class. Leveraged inverse ETFs typically return -2X or -3X returns.
Here are a few of the most prominent inverse ETFs listings:
| Product | Index | Asset Class |
|---|---|---|
| ProShares UltraPro Short QQQ | NASDAQ | -3x |
| ProShares Short S&P 500 | S&P 500 | -1x |
| Direxion Daily Small Cap Bear 3X l | Russell 2000 | -3x |
| DB Gold Double Short | Gold | -2x |
| ProShares UltraShort Bloomberg Crude Oil | Energy | -2x |
The Ins and Outs of Inverse ETFs
As with any security, there are nuances involved with trading inverse ETFs. In fact, the first chapter in any book titled What Is an Inverse ETF? should explain that these products are intended to be short-term trading vehicles. Because inverse ETFs use derivatives to assume bearish market positions, they must be rebalanced every day to reach their stated objective. This can lead to diverging intermediate-term returns and can make holding inverse ETFs problematic over time.
Physically trading inverse ETFs is very similar to buying and selling shares of stock. To illustrate, assume that Gerry the gold trader believes that the U.S. Federal Reserve (Fed) is planning a ¼-point surprise interest rate hike. The Fed’s actions would likely send the price of gold toppling as traders begin to price in a stronger USD. To get in on the action, Gerry decides to short the bullion market with an inverse ETF following the below scenario:
- Near-term CME gold futures are trading in the neighborhood of $1,875.00.
- Gerry buys 100 shares of Proshares Inverse Gold ETF (GLL) at $30.00 per share.
- Once the trade has been executed, Gerry has secured a -2X short position in relation to the Bloomberg Gold Subindex.
- If the value of gold falls, the price of the ProShares Inverse Gold ETF (GLL) is in a position to rally. Should price reach an acceptable level, Gerry can elect to sell the inverse ETF and realize a profit.
- In the event that bullion appreciates in value, prices of the ProShares Inverse Gold ETF will fall. Unfortunately for Gerry, this scenario prompts a capital drawdown and may generate a realized loss.
Essentially, Gerry has shorted gold from the current market price ($1,875.00). If the value of gold falls, then the price of GLL will increase and generate market share.
However, it is important to understand that Gerry’s bearish exposure to the gold market is indirect in nature. This means that the combination of derivatives employed by the GLL may or may not track the price of gold accurately. In addition, the margin rules put forth by the U.S. Financial Industry Regulatory Authority (FINRA) are strict regarding inverse leveraged ETFs. As a result, Gerry’s ability to apply leverage to the short side of the gold market is far less than that found in the futures markets.
If you’re still confused about how to answer the question of what an inverse ETF is, think of it this way: An inverse ETF is a means of indirectly shorting the market with limited leverage. It’s as simple as that.
Are Inverse ETFs Right for You?
One of the great things about modern finance is the wide variety of opportunities available. Active traders can profit from buying or selling many different shares and ETFs, as well as standard futures and options contracts.
To learn more about the possibilities of this exciting time in finance, speak with a Daniels Trading broker today.
