How To Be A Better Bear: Short Selling vs. Inverse ETFs?

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ETFs have become a staple product in most traders’ and investors’ arsenals. Active traders have embraced ETFs, and ETF issuers have responded by giving these traders tactical access to nearly every corner of the global investment market. Inverse ETFs or “bear funds,” which increase in value as the underlying asset declines in value, are one such tactical tool. But is it better to short-sell or buy an inverse ETF? To answer the question, we’ll look at when it’s prudent to be bearish, how to short-sell, how inverse ETFs work and then which method fits best with your particular financial goals or trading strategy [see also How To Take Profits And Cut Losses When Trading ETFs].

How to Be a Bear

Being bearish means you expect an asset’s price to decline, and therefore take a position to potentially capitalize if your expectation comes to fruition.

While it has become much more commonplace for retail investors to take short positions, or buy inverse ETFs, many are still leery, viewing it as too risky. Yet shorting or buying inverse ETFs can be a valuable tool, and can actually help traders and investors achieve their financial objectives. Markets don’t always rise, so if you’re only trading the long side you’re missing out on profit potential when markets decline. Utilizing short-selling strategies or buying inverse ETFs during declining markets, and using bullish trading strategies during rising markets, means you’re maximizing your profit potential across both rising and falling markets [see Short ETFs: Everything You Need To Know].

What Is Short-Selling?

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When you buy an ETF, you’re anticipating the price will rise and that at some point in the future you’ll be able to sell it for a higher price than you paid. You buy first then sell. With short-selling, you’re anticipating the price will decline; therefore you want to sell at today’s price, and then hopefully buy it back at a lower price in the future, with the difference between the two prices equaling your profit. You sell first then buy.

Assume the SPDR Gold Trust (GLD, A) is trading at $130, and you believe it’ll decline in value. You short-sell 100 shares, and receive $13,000 (less fees and expenses) into your account. You have $13,000 from the sale but your account shows a negative 100 share balance, which means you’ll need to buy back those shares, called “covering,” at some point in the future. If the price rises to $150 and you cover, it’ll cost you $15,000 to buy back 100 shares, resulting in a loss of $2,000 plus fees. But if the price drops to $100 and you cover, it only costs you $10,000 to buy 100 shares, and you pocket $3,000 in profit less fees.

The main benefit of short-selling is that you can profit from falling asset prices. Since many investors only trade on the long/bullish side, by trading on the short side as well, you’ll have more opportunities to trade and profit [see 7 Rules ETF Day Traders Must Know].

The main risk of short selling is that while your profit is capped–a stock can only fall to zero–your risk is theoretically unlimited. If you have a short position, the asset you’re short in could rise indefinitely forcing you to cover at a higher and higher price. This shouldn’t scare you though, as you can cover a short position at any time. While you may sustain losses most experienced traders don’t view shorting as any more risky than taking a long position, as long as you keep your risk controlled and use stop-loss orders to help protect capital.

Also, if you’re short in a stock when a dividend is paid out, you’ll need to pay that dividend. A notice will be sent beforehand, warning that you may be liable for a dividend payment if you hold your short position past the specified dividend date. You’re liable for the dividend because in order to sell before you buy you need to borrow those shares from someone who already owns them. These are both automatic processes your broker takes care of.

How Do Inverse ETFs Work?

An inverse ETF moves in the opposite direction of the underlying asset. For example, if the SPDR S&P 500 (SPY, A) moves up 1% today, the Short S&P 500 (SH, A) ETF should drop by 1%. An inverse ETF creates this effect by taking positions in multiple securities, so the daily gain or loss is the inverse of the traditional index, as in the example above [see also How To Swing Trade ETFs].

Inverse ETFs are generally only intended to provide the inverse return on a daily basis. If the Dow Jones Industrial Average ETF (DIA, A-) moves down 5% over a week or a month, the Short Dow 30 ETF (DOG, A) won’t likely be up 5%. Due to compounding returns and losses on an increasing or decreasing ETF price, over the longer-term you can expect some disconnect between gains/losses on a tradition ETF and the losses/gains on the corresponding inverse ETF.

Some ETF and ETN issuers offer inverse ETFs that seek the inverse return on a traditional index over the course of a month. Beyond one month though, the same disconnect typically occurs.

The main benefit of an inverse ETF is that it allows you to quickly and easily take advantage of falling asset prices. Assuming you pay for the position outright (no leverage) your loss is also capped at the amount you invest, since the price of the ETF can’t drop below zero.

The main risk is that inverse ETFs don’t always act as anticipated. While on a daily basis you can expect an inverse return on the underlying index, over the longer-term the return on your ETF can vary drastically from expectation.

Which Approach Is Best: Shorting or Buying Inverse ETFs?

If you want specific dollar-for-dollar gains as an asset price drops, you’ll want to go short. By shorting the specific stock or ETF you’ll know that if you have a 200 share position and the ETF drops by $1, you’ve increased your unrealized profit by $200. And as long as the ETF continues to decline, your unrealized profit will continue to mount. The downside is that you’re responsible for any dividends that may arise while you’re short. You also may receive margin calls on your trading account if the ETF moves against you (goes up). Shorting is a viable strategy for day traders, swing traders and longer-term traders alike [see also ETF Call And Put Options Explained].

Inverse ETFs are excellent day trading candidates as many are based on the daily inverse price performance of an underlying index. Over short periods of time you can expect that the inverse ETF will perform “the opposite” of the index, but over longer periods of time a disconnect may develop.

Therefore, inverse ETFs are typically used for short-term trading opportunities, or to take advantage of sustained downtrends in major asset classes where sizable gains are likely, even in spite of a possible disconnect.  If an index such as the S&P 500 declines by 20% over a couple of weeks, even if the Short S&P 500 (SH) ETF doesn’t gain exactly 20%, a significant profit can likely still be realized.

The Bottom Line

There isn’t a definitive answer on which is better, shorting or inverse ETFs; both have merit and are utilized by all different types of traders. Inverse ETFs may not act exactly how you expect over the long-term since, typically, the fund’s goal is to provide inverse price performance over a specific time frame only. Shorting doesn’t have this drawback, but your potential risk is higher and you may end up having to pay dividends. If you’re a day trader, utilize both methods. For longer-term traders, you’ll need to determine which is more risky to you: the sometimes unpredictable returns associated with inverse ETFs, or the uncapped risk and possible dividend payments on a short position.

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Disclosure: No positions at time of writing.

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