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In most, if not all markets, and in this volatile time in particular, the ability to enter and exit a position quickly (at a price close to the last trade price) is of critical importance. With markets recently in a downdraft, some investors who have exited long equity positions are thinking of inverse ETFs as a way to continue directional investing, instead of sitting on the sidelines with cash.

The chart below shows the dollar volume per second two ways for each of the 50 most liquid of 96 inverse ETFs: (1) based on 3-month average share volume and yesterday's price; and (2) based on yesterday's share volume and price.

Rather than computing the dollar volume per day, a more conventional calculation, we computed the dollar volume per second, which relates more directly to the time frame involved in entering or exiting a position. Since you would not want to wait the 6.5 hours of a day (23,400 seconds) to get in or get out, a full day's dollar volume is not as useful a number to comprehend execution time as one second's dollar volume.

In a rapidly moving market, seconds, not hours, are the key time frames.

Of course, dollar volume increases or decreases as conditions change, but historical averages can still give some, although highly imperfect, idea about which securities have potentially acceptable liquidity.

If you feel you need to exit in 5 seconds, for example, you could consider five times the per second dollar volume as the largest position you might take. Alternatively, if you are willing to wait one minute to exit, you could consider sixty times the per second dollar volume.

Remember, however, you won't be the only investor seeking the exit door. Think what happens when someone yells "fire" in a crowded room -- there is problem with everybody seeking the same door which is only intended for "normal" flow through. Therefore, the per second numbers are more optimistic than likely reality, if markets become suddenly hot in either an up or down direction. In any event, per second numbers are easier to conceptualize than per day numbers when thinking of execution time.

You'll see in the table below, that there is not much liquidity in most inverse ETFS, and virtually none for large positions.

For example, if you would normally have a $1,000,000 long position in SPY, you could not safely have a $1,000,000 position in its inverse (SH), which yesterday traded only about $10,000 per second (and only about $6,000 per second on average over the past three months).

At yesterday's volume, it would have taken 100 seconds to liquidate a $1,000,000 SH position -- and that is if nobody else was trying to exit at the same time. That's too long for a key index related product with a market order, which you would most likely use in an "emergency" exit. In a rapidly changing market, limit orders near the last trade can leave you unfilled and trapped in your position while the price runs away from you.

Conventionally shorting SPY itself, or use of futures contracts, is much more liquid and is safer in terms of clean exits than use of the inverse fund SH. The double short SDS is much more liquid than SH, but you may not want the gearing of a two times inverse fund. Even SDS dollar volume pales in comparison to the liquidity of shorting SPY directly.

With proper use of stop loss orders, the often mentioned concern about theoretically possible unlimited losses in shorts, is a non-issue.

Holdings Disclosure: As of May 19, 2010, we do not have positions in any other securities discussed in this document in any managed account.

Disclaimer: Opinions expressed in this material and our disclosed positions are as of May 19, 2010. Our opinions and positions may change as subsequent conditions vary. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. All of our published material is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance, and there is no guarantee that any forecast will come to pass. Do not rely solely on this material when making an investment decision. Other factors may be important too. Investment involves risks of loss of capital. Consider seeking professional advice before implementing your portfolio ideas.

Source: Inverse ETF Liquidity: Critical Criterion