We've had a good run of the bull market, but unfortunately, a correction seems to be imminent (if not already here). Signs of a market correction have been flashing here and there for a while now - albeit mixed ones - and on July 30th, the market had its biggest single-day dip since February. The threat of higher interest rates and the worrisome news of international markets turning rather sour, coupled with all the global turmoil, is creating a rather tense market. This bull market has been running for quite some time, and the time just might be here when bulls needs a little breather.
Now, this is not an article about how the market is due for a long overdue correction. Instead, the focus here is on how to cut losses, or even profit from a possible market correction instead of losing from one. The market is constantly changing, where it's rising one moment and falling the next. Along with changing markets, it is often required to change gears and go from the "offensive" - buying stocks - to the "defensive" - liquidating some assets. Selling is a great a defense in a bear market; however, one overlooked tool that provides not just a great defense in such a market, but even a possible offense, are ETFs. Now, generally ETFs aren't associated with a great defensive strategy in a declining market. However, I'm not just talking about any normal type of ETFs, but about inverse ETFs. They're rather uncommon in an investor's portfolio, especially given the recent bull market and the fact that they're relatively new to the game - but now is a great time to look into them with the current market situation.
Inverse ETFs and other ProShares
The first inverse ETFs for the biggest market indicators were introduced only eight years ago in June 2006 by Short Dow30 (NYSEARCA:DOG) and Short QQQ (NYSEARCA:PSQ). They were introduced by ProShares, along with 8 other ETFs that have now grown to over 140 ETFs during the past eight years. Inverse ETFs are unique in the fact that they correspond to the daily performance of an index or benchmark - meaning they are meant to go up with a declining index or benchmark over a trading day. For example, if DJIA goes down 2% one trading day, DOG will go up 2% the same trading day.
The other unique ETFs offered by ProShares are leveraged ETFs, ETFs that can return at 2x (Ultra) or 3x (UltraPro) the percent change of return of a particular index or benchmark for a trading day as measured from one NAV calculation to the next. The Ultra and UltraPro objectives also apply to the inverse ETFs as well. For example, if DJIA drops 2% in a trading day, DJIA's UltraPro Short Dow30 (NYSEARCA:SDOW) will go up 6%. These multiple objective ETFs offers extreme flexibility and larger profits (and losses) than a normal 1x objective ETF. Below are some inverse ETFs for some common market indicators and benchmarks (Information for chart obtained from ProShares).
You can clearly see the power of inverse ETFs during the 2007 recession. Following the 2007 recession, you can also see the devastating results if the inverse ETFs are not timed correctly or if exited too late. (Images below were made using FreeStockCharts).
Over the past few days starting from July 27, the market experienced a drop, with DJIA dropping 413 (-2.43%) yielded a 7.29% profit with SDOW (an exact 3x).
Inverse ETF vs. Shorting
You may ask, why these inverse ETFs, when the option of shorting is available? Well, these inverse ETFs provide a few benefits while taking away some of the risks and headaches of shorting. For one thing, these inverse ETFs can be treated just like any normal ETF, which have the advantage of being traded like normal stocks. The other advantage of ETFs over shorting is the lack of a need of a margin account, which offers a great way to bet against the market for those who don't want all the hassles, headache and extra costs that may come with a margin account. This leads us directly into the lower risks associated with these ETFs. Shorting is known for its risks, particularly that of running unlimited losses - as theoretically, a stock can shoot up to infinity. Since these ETFs can be treated as normal ETFs, they don't run that risk - they can only run down to a limit: zero.
Inverse ETFs Against Your Odds: The Rise and the Fall
Betting against the market is by no means "safe." Shorting is very risky indeed, especially when betting against the market as a whole, and inverse ETFs do make it a little safer and less of a headache, but is still risky. Part of this stems from the fact that the market goes up more often than it goes down - but do remember, what goes up must eventually come down. So despite the probability of betting against the market working against your favor (and another factor that will be discussed shortly), there is one thing going for your favor - part of the compounding nature of these ETFs.
Inverse ETF For Your Odds: The Two Advantageous Sides of Compounding
Compounding is a beautiful thing. Especially with dividends and interest, and twice as much to love with inverse ETFs. Why twice as much? Because with inverse ETFs, there isn't just compounding growth but compounding decay as well.
So the first part, compounding growth gives you a greater return than if it wasn't compounded. In simple terms, when the market will go down and the inverse ETF goes up, whatever percentage change it is, it will compound with each change. So the growth will be exponential (albeit to a small degree). To demonstrate this, let's consider a hypothetical situation where the stock market goes down 5% every day for 3 days. The ETF (hypothetically let's say it's $25) will go up 5% everyday, leading to compounding where Pricefinal = Priceinitial * ΔXn = $25* 1.053 = $25 * 1.16 = $28.94, where ΔX is the change in percentage and n is the number of times it happens. So the inverse ETF in this hypothetical case would make you a profit of $3.94 with 3 consecutive 5% decreases of the market instead of $3.75 if it wasn't compounded.
The second part of compounding is its dual nature, meaning that it is also applied during decay. When it is applied during decay, it will actually provide a smaller loss than if it wasn't compounded, offering you a dampening effect on your losses. Again with the same math as above, $25 * .953 = $25 * .86 = $21.43. This makes you a loss of $3.57 with three consecutive 5% rises in the market instead of a $3.75 loss if it wasn't compounded. These compounding growth and decay however must be monitored with caution, as this can also turn ugly.
The Ugly Side to Compounding
The ugly part of compounding is the third interesting property from this compounding nature of these ETFs. Yes, compounding grows your profits greatly if you're right, and can dampen your losses if you're wrong, but this last property leads to the value of these ETFs to depreciate over time. This effect is quite negligible under a short period of time, especially when the market is heading towards a particular direction (i.e., a market that doesn't have many sharp turns); but over a long period of time, especially in a volatile market, this property can slowly eat away at the value of the ETF. In a hypothetical example, if the market were to experience a 10% increase followed by a 10% decrease the ETF would yield $25 * 1.1 * 0.9 = $24.75, a loss of 1%. This is very important to note, as a long hold would slowly depreciate the value of it over time even with a 0% net increase. To illustrate this let's consider a hypothetical market index of 100. If the index were to fall 10 points to 90 that would be a 10% decrease. Now say the next day the index were to go back up to 100 this would be a 11.11% increase, not a 10% increase (10/90 = .1111). This is not good for the ETF as this would translate to $25 * 1.1 * .8889 = $25 * .978 = $24.44. This means even though the market in the end had a net change of 0 points, the ETF went down 2.2%. If the market was always heading in only one direction, this phenomenon would not occur.
These types of ETFs were designed to return the % for a single trading day; and thus over several trading days, the total percentage returned will begin to be slightly skewed from the 1x, 2x, or 3x objective, especially in a volatile market (other reasons include fees and expenses of the funds). For this reason, these ETFs are advised to be held only for a short period of time (ideally one day and definitely no longer than a month), not a long hold. They are rather safer to hold over slightly longer periods of time (i.e., the returns would be more consistent with the objectives) as long as the market follows a particular trend (up for these inverse ETFs) without much zigzagging (i.e., a non-volatile market). This hold, however, should still be kept as short as necessary, and should never be a long hold. As soon as the market starts to turn again, it is crucial to get out as soon as possible. For this reason, it is important to reiterate how important timing is with inverse ETFs, especially with Ultra and UltraPro ETFs - and they are recommended to be monitored daily. As a precaution it is recommended to put stop loss orders with these ETFs as without daily monitoring, the ETF can change in value quite drastically.
So with the compounding effect, the overall take-home are these three messages: 1) The profits are greater because of compounding 2) The losses are dampened because of compounding 3) The ETFs depreciate with changes in direction of the market (especially in a volatile market), so you never want to hold an inverse or leveraged ETF for an extended period of time in general but is slightly safer when the market is expected to follow a general trend (i.e., without much zigzagging). As a consequence of this last message, the 2x and 3x objectives are sometimes not always exactly 2x and 3x of the index or benchmark, but usually do depict the indicators they're meant to depict as closely as possible for a given day, but will usually deviate below the objectives the longer they're held.
Taxes and Damage Control
One very useful feature provided by either inverse ETF or shorting is affording some means of damage control. The profit provided by the inverse ETF will be able to offset the losses incurred during a declining market. And the flexibility offered by the Ultra and UltraPro offers big damage control even when taking up a small percentage of your portfolio. This is particularly helpful when you don't want to sell because of either taxes, or dividends among other common reasons. One small thing I do want to note about taxes is that in the end, you always do have to pay taxes; no matter if you sell now or later, you pay taxes on the capital gain. So fear of not selling in a declining market over a security held over a small time (I say over a small time because of the different tax brackets for a short hold over a long hold (1+ year)) is not as a big deal as many think (unless the security is held for a long time in which case the taxes may be considerably different).
Now by no means am I screaming panic and suggesting you sell off your whole portfolio. The market looks like it is indeed entering a correction where these inverse ETFs can be a great tool in damage control and does offer means of reaping rewards if you do decide to use them to such means with caution. Even if the correction does not take place now and takes place months from now, you're still looking at a very valuable - and often overlooked - tool for your portfolio.
Disclosure: The author is long SDOW. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.