By Brandon Clay
Shorting the market is a tricky task. For one, you’re betting against the long-term upward bias of the market. Over time and on the whole, stocks tend to go up. When you go short, you’re disagreeing with that trend. That’s why good short trades are usually quick and focused.
The other issue relates to how stocks act. Stocks that fall hard often bounce higher, sometimes sharply. If you’re on the short end of the trade, your account can suffer very quickly and not recover. Anyone who went short the market at the March 2009 low and is still in that position could be down 60% or more.
With those caveats, we still think now may be a good time for aggressive investors to consider a strategic short. The European debt crisis is far from over. Despite some positive press releases, the EU’s mettle is still being tested by Greece, Spain, and Portugal. Just this week, the head of the European commission, Jose Manuel Barroso warned that democracy could ‘collapse’ in some countries without a fresh infusion of cash. Barroso even raised the specter of fascist dictatorships rising. His goal seems to be more cash flow for the overly debt-laden economies. Great for them, but it adds even more strain to the German and French economies that are already bearing the burden of their smaller EU siblings.
Because of the extensive trading relationship between Europe and the U.S., our biggest stocks are affected as well. We think the recent short-term rally is a head-fake. Yesterday, stocks traded over 2% higher on low volume. This suggests many big players are looking for safer footing in an erratic market. The current short-term rally may have just about run its course.
One way to play the struggling market is with ProShares UltraShort S&P 500 (NYSEARCA:SDS). SDS is a leveraged inverse ETF that seeks to earn twice the inverse of the daily performance of the S&P 500 index. In other words, if you think the S&P 500 is going down, SDS tries to cash in on the move and give you 2X the benefit for your efforts.
Before jumping on SDS, be sure you understand how leveraged ETFs work. As we explained in our 3X Impact article, leveraged ETFs reset their exposure level every day. Leveraged inverse ETFs do so as well. If the market goes 25% in your expected direction over several days, the lack of a compounding effect means you won’t realize the full 25% appreciation. Be aware of this whenever you trade a leveraged ETF.
One final note: we mentioned ‘strategic short’ because of the nature of the market. Manage your inverse trades as you would any other risky position. Setting realistic profit targets and adequate stops help control the risk of a short. Stops may lock in your losses or gains, but it’s better than holding an open position with no safety net. All the best.
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Disclosure covering writer, editor, publisher, and affiliates: No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.